House Bill Shows Challenge of Regulating Crypto Without Giving TradFi a Free Pass

McHenry and Thompson's proposed bill, while hailed by industry insiders as a landmark, introduces significant regulatory uncertainty by creating a new digital asset class. However, the bill's attempt to resolve regulatory arbitrage by exempting restricted digital assets from parts of the securities laws, while preventing token sales from representing equity interests, creates a new problem: the bill lacks clear definitions for these terms, leaving the SEC with the authority to determine which tokens constitute equity or debt securities.

House Bill Attempts to Navigate Crypto Regulation Labyrinth, But Raises Concerns

Amidst the burgeoning crypto landscape, the House Financial Services Committee Chair Patrick McHenry (R-NC) and Agriculture Committee Chair Glenn "GT" Thompson (R-PA) have proposed a draft bill that aims to delineate the regulatory boundaries for crypto assets. While the bill has garnered praise from certain crypto industry proponents, it raises fundamental questions about the feasibility of exempting tokens from securities laws without creating regulatory loopholes that traditional securities issuers can exploit.

The proposed legislation seeks to introduce a new asset class termed "digital assets," encompassing subcategories such as "digital commodities" and "restricted digital assets." The intent is for crypto tokens to be issued initially as digital commodities or as restricted digital assets that subsequently transition into digital commodities upon reaching a threshold of decentralization.

Restricted digital assets, while meeting the criteria of securities under the Howey Test, would be exempted from certain securities laws. However, this exemption hinges on the token issuance meeting six specific qualifications, including a prohibition on the sale of "equity securities, debt securities, or debt securities convertible or exchangeable to equity interests."

This provision, intended to prevent regulatory arbitrage, poses a significant challenge. The bill does not define "equity securities" or "debt securities," leaving room for interpretation by the Securities and Exchange Commission (SEC). Given the similarities between the governance structures of many decentralized applications (dapps) and decentralized autonomous organizations (DAOs) and those of corporations, the SEC could deem most, if not all, crypto tokens that satisfy the Howey Test to be equities subject to traditional securities law disclosures.

Alternative approaches to removing SEC discretion while preventing regulatory arbitrage face similar hurdles. A bill that excludes crypto from the Howey Test would render securities laws technologically biased, favoring blockchains over other technologies. Defining equity securities as solely "stocks" would leave courts to determine what constitutes a stock, creating a new judge-made test that, like the Howey Test, requires litigation for legal certainty. Defining equity securities as issuable only by state-chartered legal entities could lead to companies converting to DAOs while maintaining the same governance structures.

The bill also poses other concerns. It grants expanded jurisdiction to the Commodity Futures Trading Commission (CFTC) without providing additional funding. It seemingly exempts DeFi exchanges from adhering to the same investor protection provisions as their centralized counterparts. Additionally, the CFTC would be authorized to grant retroactive or prospective exemptions to large segments of digital commodity markets from customer protection provisions, rendering the bill's regulation of exchanges and brokers discretionary.

Despite the bill's ambition, it highlights the inherent challenges in creating crypto legislation that simultaneously exempts tokens from securities laws and maintains regulation of traditional securities issuers. The proposed distinctions between digital commodities and restricted digital assets, coupled with the lack of clear definitions for key terms, create potential loopholes that could enable traditional securities issuers to bypass securities regulations by issuing crypto tokens.

As the crypto ecosystem continues to evolve, policymakers face a formidable task in navigating the complexities of digital asset regulation. Striking an appropriate balance between fostering innovation and protecting investors requires a comprehensive and well-defined legal framework that can address the unique challenges posed by this rapidly evolving asset class.