The discussion draft of a new crypto market infrastructure bill proposes a new regulatory framework based on shared jurisdiction between the CFTC and SEC, expanded CFTC authority, and new SEC exemptions for token sales and distributions.
Topics covered:
- Summary and discussion of the framework proposed in the discussion draft
- An SEC exemption for digital commodity offerings
- Summary of disclosure requirements under new exemption
- What is a "Mature blockchain system" under the proposed framework
- CFTC's expanded jurisdiction over spot transactions
- SEC updates on integrating TradFi with blockchain
Transcript
The following transcript of this discussion was edited for clarity.
Karen Ubell: Hello, and welcome to this audio alert from Goodwin. I'm Karen Ubell, co-chair of the Digital Currency & Blockchain group. I'm joined by Mitzi Chang, also co-chair of the Digital Currency & Blockchain group and co-chair of the Fintech practice, and John Servidio, partner in our Boston office.
Today, we'll be discussing some recent policy developments concerning the regulatory framework for digital assets. Primarily, we'll focus on the discussion draft of the market infrastructure bill shared last week by the House Committee on Financial Services, the House Committee on Agriculture, and their relevant subcommittees. We'll provide a very brief summary of the draft, which is hundreds of pages long, representing a Herculean effort by the staff and others to pull something together that is so comprehensive.
We'll also share some of our thoughts on a few of the key components. But, before we do that, we'll each share a top-line thought.
This is an initial draft and much remains subject to change through revisions, amendments, et cetera. But this is certainly something I think we and issuers can work with in its current form. There are certainly some pockets and room for improvement, but if it were to be passed in its current form, it provides some level of certainty. I think it's definitely something we could work with. Mitzi, what was your takeaway from reading this?
Mitzi Chang: Thanks, Karen. I agree. For those of us who practice securities laws, it has a very similar format and structure to some of our existing securities laws, despite the fact that it is exempting digital assets outside of that framework. It's pretty clear. I do think there are some aspects of it that are very similar to existing securities laws, which we can talk about later, such as Form 144 and Rule 144 for affiliates, that it looks like they've borrowed from.
John Servidio: With this legislation, the SEC (Securities and Exchange Commission) probably gets most of the headlines, but, in reality, it's really more about the Commodity Futures Trading Commission (CFTC) and the fact that it expands its jurisdiction a lot by including spot transactions, which it didn't have jurisdiction over before. At least to the extent the spot transactions are for spot digital commodity transactions, I think that's the big takeaway. It also aligns a lot of the new regulation with those that are already in place for the CFTC and the SEC, so it's a really good start.
Karen Ubell: Great. OK, let's dig into some of the details. Starting primarily with the SEC Securities Act, which relates to the offer and sale of securities, and, as you can imagine, the offer and sale of digital assets. It separates the asset from the investment contract. In reality, it's a separation of the transactions from the asset itself. We're basically separating out those two things to potentially allow the investment contract sales and transactions to be regulated but without necessarily causing the digital commodity, which is the new term that has been phrased, to be traded with high levels of liquidity and distributed and other pieces of the puzzle that many of us have struggled with when trying to launch new protocols and new token assets.
The draft includes the provision that the investment contract does not include the investment contract asset. One investment contract asset is a digital commodity. A "digital commodity" is that which can be exclusively possessed and transferred person-to-person without necessarily relying on an intermediary; recorded on a blockchain; and sold or intended to be sold or otherwise transferred pursuant to an investment contract issued in either a registered offering or an exempt offering. That leads us to the new exemption, which is a new provision whereby if a blockchain network has been certified as a mature blockchain system or there is an intention to decentralize and achieve mature blockchain system within four years, the issuer can sell up to $150 million per year for those four years on a 12-month look back so long as disclosures have been provided. As Mitzi mentioned, this is very similar to a regime that we're used to in which there's a disclosure-based governance provision that gets the information out to potential investors, although it is somewhat unusual to have this under the exemptive framework. But we see it much like what we saw with Regulation Crowdfunding and crowdfunding rules.
After the transaction, no purchaser may own more than 10% of the total amount of the outstanding digital commodity. This is a new section, section 4(a)(8). If you're relying on this, you must file an offering statement. The final form is going to be prescribed by the SEC, but there are general buckets that were included: financial information; description of the issuer and its operations, including source code; transaction history; protocol economics; a plan of distribution; a use of proceeds; and the development plan to achieve the mature blockchain system designation and certification. We'll also see a lot of risk factors included. There are also ongoing disclosure requirements, both semiannual and current reports, so any material changes will also need to be reported during that four-year period. Anyone who is continuing to take advantage of the exemption will also need to report any changes. The other alternative is that either the sales are no longer ongoing or there is an exchange in which this is listed for trading that already provides similar disclosures, although the exchange may be relying on the issuer's disclosure. So, it's yet to be seen who will go first and when those disclosure obligations will fall away.
This continues until there is a certification of a mature blockchain. Once it is a mature blockchain network, it may have ongoing certification requirements, but it can generally trade and sell freely and will have ongoing disclosure obligations to remain listed on an alternative trading system (ATS), national exchange, or digital commodities exchange. Will the exchanges push the issuers to continue to provide these types of disclosures, or will the exchanges pick up this obligation, much like we've seen them do in Europe under Markets in Crypto-Assets Regulation (MiCA)? The question then is, What's a mature blockchain network?
The next step is how can you achieve certification for a mature blockchain network? So, any issuer-related person or affiliated person via a filing with the SEC can certify that the blockchain is now mature. The general maturity criteria are not controlled by any person or group of persons under common control. You can make that filing with the SEC, which creates a rebuttable presumption. Unless they challenge that within 60 days of filing, then you can move through as a mature blockchain system.
How do you establish, under this draft, whether you are a mature blockchain system? That can be established under various criteria. We'll run through them quickly. There's a lot more to be explored here. We'll see if there will be additional rules that will be promulgated under this or if these can stand alone. I'm hopeful that we can have these stand alone, so we don't have to continue to wait to put this exemption into play.
The digital commodity has a market value substantially derived from the programmatic functioning of the blockchain system and the promised functionality of the digital commodity, and its value has been substantially completed. It's a functional system. What you have promised people will be able to do, they are able to do, and the intended functionality is there.
A mature blockchain system is composed of open-source code and doesn't restrict or prohibit, based on the exercise of unilateral authority, any person from engaging in activities of the blockchain system. It's a programmatic system, so it's operating and functioning on a rules-based system determined by the system source code and not involving any reliance on any single person. For system governance/no unilateral authority, importantly, no person beneficially owns in the aggregate 20% or more of the total units or can unilaterally direct the voting of 20% or more of the outstanding voting power of the system based on a governance protocol.
It's also an impartial system. The digital commodity issuer and others do not possess unique permission or privilege to alter the functionality or operation of the blockchain system unless the alteration is, according to the rules-based process, implemented to fix vulnerabilities or adopted through consensus or agreement of a decentralized governance. I think the disclosure-based system is really valuable. It's not going to be too heavy of a lift. It seems tailored to what is appropriate for a blockchain system and the investors and purchasers of that token or digital commodity.
Mitzi, you and I have talked quite a bit about the exemption specifically being available to US issuers only, which aligns with the stated goals of bringing crypto back to the US and having this be a technology that is going to grow and thrive in the United States. So, making this available only to US issuers. We'll see if that remains, but I think it will. Mitzi, what was your reaction there?
Mitzi Chang: Yeah, I definitely thought it was interesting. Not all exemptions and rules apply to everybody, but for the most part, non-US folks and companies and issuers can use our securities laws and exemptions therefrom, so I definitely thought this was interesting as drafted. It'll be interesting to see if that gets left in or left out based on the discussion draft, depending on who's in the room and who's lobbying for what, but that will remain to be seen.
Karen Ubell: I think there's also another kind of big open item here, which was intentionally left somewhat open to rulemaking by the SEC: what to do with token projects and issuers and digital commodities and blockchain systems that are already out in the open and operating and may have launched via an offshore structure. I think that may be influential in that discussion, and where this ends up, of what do we do with projects that have a token and digital commodity that are already outstanding and may have launched from an offshore structure. Are they unable to take advantage of this?
What happens if you intended to have a mature blockchain system, but at the end of the four years, you're not able to get to that certification point? So far, it feels like there's nothing existing in the bill to kind of punish that behavior, except, I presume, that you may become an actual kind of backdoor public company that has to comply with the full suite of securities regulations. That's another kind of open question as to what the teeth are on that provision.
The draft appears to contemplate state law preemption, which is important here to make this a workable regime that would allow for the federal preemption and the federal structure to allow this technology and these kinds of offerings to thrive.
For liability, the SEC has anti-fraud and anti-manipulation authority under Rule 10b-5 and Rule 17a, which is materially false and misleading disclosures, and then Rule 10b-5 being fraud as you enter. There also may be private rights of action under those provisions under this exemption. I think that'll remain to be seen. For trading, it seems that an ATS-style digital commodity trading platform under the securities laws is emerging. We think that's really an important piece of this — what happens after these exempt transactions, where can they trade, and allowing the technology and the assets to continue to be liquid, have liquid markets grow, and continue a broader distribution.
There are a lot of changes here with respect to the primary offerings and secondary offerings of digital assets under the securities laws. But a lot of this bill focuses on the CFTC and the Commodities Exchange Act. What is changing in the CFTC's authority and jurisdiction, John? What's the rest of this bill that we haven't talked about yet?
John Servidio: The big headline is that it gives CFTC jurisdiction over spot trading, which it hasn't had before. Particularly with trading with spot transactions of digital commodity transactions, pretty much anything that the sponsor or the token elect to be identified as a spot commodity would probably opt into and be subject to CFTC jurisdiction, which may surprise a lot of people. It also really expands the jurisdiction of the CFTC and gives them a lot more responsibility.
That may be difficult for the CFTC, especially in a Department of Government Efficiency (DOGE) world in which they're already stretched thin under existing authority. A lot remains to be seen. Nevertheless, it's really exciting. A lot of the provisions in here right some of the wrongs in the past. It addresses some of the issues we saw with FTX Trading by prohibiting prop trading by exchanges. It also requires the traditional separation of powers or rights and duties of the traditional futures market. The exchanges are separate from futures commission merchants (FCMs), and the FCMs' custody of their assets at qualified custodians, so there's not one big bubble of risk like there would be with, say, a traditional crypto exchange like FTX. It melds the best of the new regime, the new regulation for crypto assets or digital commodity assets, with some of the traditional regulations of the CFTC but then brings in spot or cash trading too. So, I think that's a really good step in the right direction.
But it really sets out the frameworks for how a spot digital commodity exchange will work. The initial plan is to make it work just like a regular designated contract market (DCM) or derivatives exchange. Same thing with any kind of registered intermediary. It's going to work just like it always has, but now it will also include spot trading as well as, potentially, derivatives trading on digital assets.
All that will be under the CFTC's jurisdiction. I think that's going to be helpful for participants in the crypto market. The CFTC typically has a a lighter regulatory touch. But that was in a different world in which, historically, only institutional traders touched commodities, but digital commodities can be very much a retail product, which introduces a lot of challenges. How do you regulate retail investors versus institutional investors? Not all of that is in the draft bill right now, but it's within the framework and still a very good start in aligning some of the old world with the new world. I think that's a place people could start with. I think it's a good place for market participants to provide thoughtful comments to their regulators and also to the CFTC and the SEC. Specifically, how is this stuff going to work? How is it going to affect me? What are the rights and obligations of this? How are these separations of powers and duties going to work for digital assets? But it's a very good start. It's going to create a longer conversation. A lot of comment letters will be submitted, and a lot of lobbying will be done, as there should be, because there are a lot of gaps to fill. But it's a step in the right direction for sure.
Mitzi Chang: I agree that it's a step in the right direction. There's a lot left open that's sort of punted to SEC rulemaking within a certain period of time. But I think, in terms of separating out what is under the regime of securities laws, it is a much smaller universe than how the last SEC viewed it. As we mentioned in the beginning with secondary trading, for example, using this digital commodity is not considered an investment contract or a transaction subject to securities laws.
The draft bill also allows affiliated persons to file a form if you are selling digital commodity units. If the blockchain system has not yet been certified as a mature blockchain, that's a little bit more restrictive than after the mature blockchain has been certified.
Karen Ubell: We've also had a couple of other updates this week from the SEC, from speeches and commentary from the new chair, Paul Atkins, in connection with some of the Crypto Task Force Roundtables. What are some updates there, Mitzi?
Mitzi Chang: There was one roundtable on the 12th of May called Tokenization – Moving Assets Onchain: Where TradFi and DeFi Meet. Like with many of these crypto roundtables, the commissioners will send out a statement or a speech prior to the roundtable starting. These are all available on the SEC website. But what I thought was really interesting for this one on May 12th were these statements from the SEC chair really working toward what I think many in the industry have longed for: this convergence of traditional capital markets with the benefits of blockchain technology. I think many of us who have been in this space for a long time have really hoped for that advancement between the infrastructure of blockchain technology and all that it offers with respect to quicker settlement, et cetera. We're already starting to see this in many of the products that are actually out there today. Commissioner Hester Peirce noted that in her statement with respect to tokenized funds that are currently trading.
We've also seen some early examples of tokenized digital securities on the blockchain with respect to public companies. But in earlier years, some of the requirements that the SEC had put on these companies were that you still need a physical transfer agent, right? So even though you were using this innovative technology, you still had to continue the use of traditional capital markets structures.
I think this was a really exciting step forward in the spirit of making the US the digital asset industry and ecosystem to be in. I think we're really starting to be in this period in which these rules could potentially catch up to the technology. I think a lot of us have seen the differences in traditional markets and rules and then blockchain technology. I think these statements that occurred on May 12th signal a really exciting advancement.
Chair Atkins did make a comment about really wanting more asset trading with platforms and potentially allowing securities plus commodities on one platform, which has not really happened yet. I think it's just really interesting given the dynamic between the CFTC and the SEC.
John Servidio: Yeah, the CFTC is slowly trending that way, too, by also entertaining things like tokenized deliveries of collateral for margin requirements, whether it's stable coins or other eligible collateral. But a lot of that remains to be seen because, historically, the CFTC and the SEC have not played well in the sandbox and don't have a long record of closely aligning. There's been a turf war and a rivalry between the CFTC and SEC. This draft legislation requires, among other things, that the SEC and CFTC enter into memorandums of understanding with respect to registered intermediaries and other things. That may be challenging. They've done it before. There have been understandings with respect to single stock option trading — of who regulates that, probably most noticeably after the Dodd-Frank rule — and the definitions and interpretations of security-based swaps done jointly by the SEC and CFTC. The SEC was able to align a lot of its regulation of security-based swaps with those put out by Gary Gensler at the CFTC. So, there is some recent track record of cooperation between the CFTC and the SEC, but this would break new ground in terms of the level of cooperation to be required to carry out some of the provisions in this draft legislation.
Karen Ubell: Thank you for joining us for this discussion of updates in the digital currency and blockchain space. Please reach out to understand more about how this new draft framework might work for your project or to discuss it with any of us. We would welcome the outreach and the discussion, and we expect more to come soon. We'll continue to update here or with written client alerts.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
