June 9, 2023

Good morning and happy Friday.

Top Points

House Agriculture Committee ("House Ag") and House Financial Services Committee ("HFSC") Chairmen unveiled a discussion draft for regulating digital asset markets.
House Ag held a hearing on the proposal, where Democrats appeared receptive to working with Republicans on improving the draft, focusing concerns on the draft's lack of CFTC funding and provisional registration framework.
House Energy and Commerce Committee held a hearing exploring use cases for blockchain technology outside of finance and payments.

Digital Asset Market Structure Discussion Draft

On Friday, Rep. Patrick McHenry (R-NC), the HFSC Chair, and Rep. Glenn Thompson (R-PA), the House Ag Chair, released a discussion draft for providing a regulatory framework for crypto markets, "Digital Asset Market Structure Discussion Draft."

Please note the 162 page draft is full of nuances, exceptions, and subconditions. For brevity, the summary below generalizes at times and focuses on key points.

Here's a helpful section by section and a two page summary put together by Committee staff. And here's the full text.

Overview

At a high-level, the bill authorizes the CFTC to oversee the digital commodity spot market and clarifies that the SEC has jurisdiction over digital asset securities. It provides regulations for digital asset intermediaries, like exchanges, and tailored disclosure requirements for token issuers and exchanges that list them for trading. The bill defines digital commodities using a functional approach focused on decentralization, allowing digital assets to transition from a security classification to a digital commodity classification once sufficiently decentralized. It also exempts certain types of digital assets offered or sold by an issuer from certain registration requirements under existing securities laws.

A Closer Look

What is a digital commodity?

Under the proposed bill, whether a digital asset is a “digital commodity” primarily depends on whether the blockchain network to which it relates is functional and decentralized. So, even if a digital asset is initially issued as a security, it may later become a digital commodity. § 102.

A blockchain network is a "functional network" if it:

(A) allows participants to use the digital asset for
- (i) transmission and storage on the blockchain;
- (ii) participate in an app running on the blockchain; or
- (iii) participate in the governance of the blockchain, AND
(B) does NOT confer any express contractual rights between the holder and issuer. § 101.

A blockchain network is a "decentralized network" if the following conditions are met:

No one person could have unilaterally altered the functionality of the network or restricted someone from using the network during the prior 12 months;
No issuer or affiliated person owned 20 percent or more units of the outstanding digital assets or had the authority to direct the voting of 20 percent or more of outstanding voting power during the prior 12 months;
The issuer or affiliated person did not contribute intellectual property to the blockchain network during the prior 3 months;
The issuer or affiliated person did not market the digital asset or blockchain network to the public or issue any units of the digital asset during the prior 3 months;
All tokens issued during the prior 12-month period were end user distributions (e.g., distributed via airdrops, mining rewards, etc.). See § 101.

Decentralization Certification Process § 204

To establish that a digital asset is sufficiently decentralized, any person may certify to the SEC that the blockchain network to which it relates is decentralized.

The certification filing must include (1) information about the filer and (2) an analysis of the factors as to why the network is decentralized. The certification shall be approved within 30 days, unless the SEC rebuts the presumption. The SEC must provide detailed analysis as to why it decided the network was not decentralized. The bill also provides an appeals process for challenging the SEC's rebuttal.

Regulation of Digital Commodity Intermediaries

To regulate trading of digital commodities in the spot market, the bill authorizes the CFTC to oversee and register three types of intermediaries: Digital Commodity Exchanges, Digital Commodity Brokers, and Digital Commodity Dealers (defined in § 102). These three entities would also be required to register with a self-regulatory organization (e.g., NFA) and comply with core principles under the Commodity Exchange Act as well as additional rules aimed at protecting customers.

For example, Digital Commodity Exchanges would have to:

Monitor trading for fraud and manipulation,
Minimize conflicts of interests,
Maintain adequate financial resources,
Keep adequate books and records,
Segregate customer and company funds, and
Certify that digital assets listed are not subject to fraud and manipulation. § 404.

And Digital Commodity Brokers and Digital Commodity Dealers would have to:

Satisfy minimum capital requirements,
Keep books and records of daily trading,
Make information readily available to the CFTC,
Adequately disclose risks related to digital commodities,
Minimize conflicts of interests, and
Comply with other business conduct standards as proscribed by the CFTC. § 406.

Restricted Digital Assets

The bill creates an exemption from existing securities laws for “restricted digital assets”—that is, digital assets that are sold by an issuer and meet the following conditions:

(i) the issuer’s total sales of the digital asset over previous 12 months did not exceed $75 million,
(ii) a non-accredited investor’s purchases of the digital asset from the issuer over the prior 12 months are less than the greater of 5% of the purchaser’s annual income or 5% of their net worth,
(iii) the purchaser does not own more than 10% of the units of the digital asset after the completion of the transaction,
(iv) the transaction does not involve equity or debt securities, and
(v) the issuer filed a statement with the SEC and made disclosures to potential purchasers regarding material aspects of the offering. § 201.

Issuers of restricted digital assets would be subject to tailored disclosure requirements most relevant to digital asset purchasers (detailed below). § 203.

And Section 202 places restrictions on the resale of restricted digital assets acquired by insiders (e.g., establishes a holding period for related persons, and a holding period, volume limitation, and notice requirement for affiliated persons). § 202.

Digital Asset Intermediaries

Anyone involved in the offer or sale of restricted digital assets must register as a broker with the SEC and FINRA. See § 201.

Further, the bill directs the SEC to allow digital assets, including restricted digital assets, to trade on an alternative trading system ("ATS") and to permit disintermediated trading. See § 303.

Disclosures

The draft would create a tailored disclosure regime for certain digital assets.

Specifically, issuers of restricted digital assets and exchanges listing digital commodities must publicly disclose information about the digital asset and its related blockchain network, such as:

Source code for the network,
A description of how to access and verify the blockchain’s transaction history,
Tokenomics (i.e. total token supply, # of tokens issued at launch, schedule for new tokens to be launched, etc.),
A description of governance, and
Other information relevant to a potential purchaser of that digital asset. (See § 203(a) for full list of items issuers of restricted digital assets must disclose and § 404 for list of items digital commodity exchanges must disclose.)

Issuers of restricted digital assets must also file annual, semiannual, and current reports detailing any material updates to the offering until a certain period after the blockchain network is certified as decentralized. § 201.

Further, someone (issuer, affiliate, or decentralized organization) must file quarterly certifications to the SEC and CFTC that disclosures relating to a digital asset and its related network are accurate. § 203. In the case of decentralized networks, a digital commodity exchange or ATS may file the certification. § 203(b).

Provisional Registration §§ 105-106

The act provides the SEC and CFTC broad authority to write rules building on the bill’s definitions and registration requirements. (See, e.g., Section 104) (directing the SEC and CFTC to further define key terms and write rules for overseeing dually registered exchanges).

Until these rules are written, intermediaries would be able to file provisional registration statements with the SEC and CFTC, which would allow them to operate their businesses without fear of enforcement actions for listing unregistered securities or violating registration requirements.

Once the rules are finalized, the SEC and CFTC could direct an exchange to delist any assets they find are not in compliance with the act or rules issued thereunder.

Other notable items:

Exemption for ancillary activities: Ancillary activities—defined to include mining, validating, publishing or updating software, or developing wallets—are explicitly exempted from direct SEC & CFTC regulation. (But not from the SEC’s or CFTC's anti-fraud and anti-manipulation enforcement authorities). §§ 309, 407.
Custody: Directs the CFTC to set minimum standards for custodians to become qualified digital commodity custodians (QDCCs) and requires digital commodity intermediaries to use QDCCs, with certain exceptions. (Note, the bill specifically authorizes the CFTC to write rules exempting digital commodity exchanges from this requirement). See §§ 404-405. It also directs the SEC to allow for broker-dealers to custody digital assets if certain conditions are met. § 304.
Stablecoins: Clarifies that stablecoins are not securities. § 301.
Bankruptcy: Clarifies that customers with digital assets held by digital commodity intermediaries shall be treated as customer property in the event the intermediary files for bankruptcy. See §§ 404, 406.
NFTs & DeFi: The bill requires studies of NFTs and DeFi. §§ 505, 506.

House Agriculture Committee Holds Hearing on Digital Asset Market Structure Discussion Draft

On Tuesday, the House Agriculture Committee held a hearing examining the discussion draft.

Key Takeaways:

Committee Democrats appeared open to working to improve the Republican led discussion draft. The two main concerns cited by Democrats and CFTC Chair Rostin Behnam were that the draft should:
- (1) increase CFTC funding levels, and
- (2) amend the provisional registration section so rules come before any registration.
CFTC Chair Behnam said he believes the bill applies the right theoretical framework for (1) defining digital commodities because it focuses on decentralization and (2) requiring disclosures that reflect items most relevant to purchasers of digital commodities—though he qualified his remarks by noting he is still working through the draft's details.
- He also consistently affirmed his view that Ether is a commodity.
Next step, is to monitor HFSC hearing next week and any comments by Senate Democrats to get a better sense of the draft’s prospects and how it might be amended.

Full in-depth summary of House Ag hearing, including notes on each Member’s line of questioning available at CHC+

👇

CHC+

House Energy and Commerce ("E&C") Subcommittee Hearing on Use Cases

On Wednesday, the House E&C Subcommittee on Innovation, Data, and Commerce held a hearing on “Building Blockchains: Exploring Web3 and Other Applications for Distributed Ledger Technologies.”

Key Takeaways:

There was bipartisan interest in understanding specific examples of how blockchain technology is solving real world problems.
In their questioning, Republican and Democrat Members asked for examples of potential use cases of blockchain technology, covering everything from adding efficiencies to small businesses' supply chain management and reducing dependencies on Big Tech, to gaming apps, AI, and even athlete NIL contracts.
Democrats raised concerns regarding the prevalence of scams and cyberattacks involving blockchains, as well as risks posed by the irreversible nature of blockchain transactions.
Republicans often voiced concerned that entrepreneurs will move offshore if Congress doesn't provide regulatory clarity soon.
Potential policy proposals raised included:
- bolstering funding for the FTC to target scams under existing authorities,
- promoting clear industry standards (e.g., third party code audits),
- bolstering consumer education, and
- providing regulatory clarity so innovators can feel comfortable building in the U.S.

Look Ahead

June 13 - 2pM - HFSC Hearing on The Future of Digital Assets: Providing Clarity for the Digital Asset Ecosystem
- More here.

Quick Hits

SEC charges Binance with 13 violations of federal securities laws, including operating as an unregistered exchange, broker, and clearing agency, the unregistered offer and sale of securities, misleading investors, and commingling funds.
- The Complaint alleges SOL, ADA, MATIC, ATOM, FIL, SAND, ALGO, AXS, COIT, and its staking a program, are securities.
- Request for relief includes asking the court to freeze Binance.US assets.
- Press Release
- Complaint
- Binance says Chair Gensler should recuse himself because he previously offered to serve as an informal advisor to Binance.
  - Article (Sam Reynolds; CoinDesk)
SEC sues Coinbase for operating as an unregistered exchange, broker, and clearing agency, and offering and selling unregistered securities through its staking program.
- The Complaint alleges SOL, ADA, MATIC, FIL, SAND, CHZ, FLOW, ICP, NEAR, VGX, DASH, and NEXO are all securities.
- Press Release
- Complaint
- Rep. Ritchie Torres commented in MarketWatch:

Judge asks SEC to submit letter explaining whether a decision to sue Coinbase confirms the agency does not intend to issue a rulemaking as Coinbase requested.
- Judge's letter.
- The SEC has 7 days to respond.
- Coinbase will then have 5 days to reply to the SEC's response.
'Crypto Communism' Has a New Meaning
- Op-Ed by Senator Tommy Tuberville (R-AL),WSJ.
Senator Bill Hagerty (R-TN) weighs in on SEC Chair comments that there's no need for more digital currency:

Senators Elizabeth Warren (D-MA) & Chris Van Hollen (D-MD) send letter to DOJ requesting an investigation into Binance's potentially false statements to Congress.
- Letter.