Markets
The Unintended Consequences of the FIT21 Crypto Market Structure Bill
There is no doubt that bipartisan approval of the Financial Innovation and Technology for the 21st Century Act (FIT21) of the Chamber is a monumental development for the US crypto industry, bringing much-needed regulatory clarity into view. However, despite its good intentions, FIT21 is fundamentally flawed from a market structure perspective and introduces issues that could have far-reaching unintended consequences if not addressed in future Senate negotiations.
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 those of CoinDesk, Inc. or its owners and affiliates.
One of the most problematic aspects of the bill is the creation of a forked market for cryptographic tokens. By distinguishing between “restricted digital assets” and “digital commodities” in parallel trading markets, the bill sets the stage for a fragmented landscape that is ill-suited to the inherently global and fungible nature of cryptographic tokens and creates the first of its kind – gentle compliance complications.
This legislative initiative stems from long-running debates over the application of US federal securities laws to cryptographic tokens and the difference between bitcoin, considered a non-security, and almost all other tokens. The U.S. Securities and Exchange Commission’s (SEC) guidance on whether a cryptographic token is a security is generally based on whether the associated blockchain project is “sufficiently decentralized” and therefore not a security contract. investment, as defined by the Howey test.
FIT21 attempts to codify this impractical test by dividing regulatory oversight over spot crypto markets between the Commodity Futures Trading Commission (CFTC) and the SEC, based on, among other things, the degree of decentralization.
While the bill appears helpful in clarifying that cryptographic tokens transferred or sold pursuant to an investment contract do not inherently become securities, it unfortunately contradicts itself by giving the full SEC authority over these investment contract assets when sold to investors (or issued to developers) for the period before a project arrives in decentralized Valhalla. Only tokens airdropped or earned by end users are initially “digital commodities” subject to CFTC jurisdiction.
The most confusing thing is that FIT21 allows simultaneous trading of restricted digital assets and digital commodities for the same token on separate and distinct markets during this period (as shown in the graph below). It is likely that many projects Never meet the bill’s prescriptive definition of decentralization and therefore trade in disjointed markets in the US indefinitely.
The bill’s proposed bifurcated market for restricted and unrestricted digital assets ignores fungibility as a fundamental feature of cryptographic tokens. By creating restricted and unrestricted asset categories, the bill violates this principle, leading to market confusion and fragmentation. This could harm liquidity, complicate transactions and risk management mechanisms such as derivatives, reduce the overall utility of cryptotokens, and ultimately stifle innovation in a nascent industry.
Implementing such distinctions would likely require technological modifications to cryptographic tokens to allow buyers to know what type of cryptographic asset they are receiving so that they can meet specific market requirements. Imposing such technological marking on restricted digital assets, even if possible, would create a “uniquely American” crypto market, separate from global digital asset markets, reducing the usefulness and value of all relevant projects.
As shown in the chart above, tokens can move between the SEC and CFTC markets if decentralized projects are recentralized. The complexity and compliance costs created by such a scheme applied to the many thousands of future cryptographic tokens are dramatically underestimated and would undermine the credibility and predictability of US financial markets. There are few examples of financial products transitioning between SEC and CFTC jurisdictions and it is almost always a tire fire (for examplethe 2020 transition of KOSPI 200 futures contracts from CFTC jurisdiction to joint CFTC/SEC jurisdiction).
The bill further underestimates the international nature of crypto token markets. Cryptographic tokens are global assets traded as the same instrument globally. Attempting to restrict certain assets within the US would likely lead to regulatory arbitrage, where the return of international markets would undermine the intent of the bill while also eroding the competitiveness of the US crypto industry.
Developers and investors outside the US are unlikely to impose similar restrictions on restricted digital assets. Therefore, new projects and investors will be encouraged to move development and investment outside of the US to avoid these requirements. This would make it extremely difficult to prevent the US digital commodities market from being flooded with non-US tokens that would have been restricted digital assets if they had been “issued” in the US.
Lastly and ironically, the law intended to protect US consumers may end up harming them due to poor market structure. Early CFTC-regulated markets for end users will be full of sellers who typically received tokens for free. These unbalanced market dynamics will most likely lead to depressed prices and increased volatility compared to narrow and international markets, with professional arbitrageurs benefiting at the expense of US retail.
This system will be further manipulated by insiders and professionals as arbitrageurs capitalize on the disjointed prices and discontinuities of price jumps caused by the transition between centralized and decentralized designations. 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 a crucial step towards addressing the regulatory challenges posed by crypto-tokens, the current proposed market structure could have unintended consequences. To protect customers and ensure the smooth functioning of U.S. digital asset markets, lawmakers must refine the bill to unify spot markets for fungible cryptographic tokens that would otherwise not be securities into a coherent regulatory framework.