Markets
The Unintended Consequences of FIT21’s Crypto Market Structure Bill
There is no doubt that the bipartisan passage of the Financial Innovation and Technology for the 21st Century Act (FIT21) by the Chamber is a monumental development for the U.S. crypto industry, providing much-needed regulatory clarity. 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 Assistant 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 divided market for crypto tokens. By distinguishing between “restricted digital assets” and “digital products” in parallel trading markets, the bill sets the stage for a fragmented landscape ill-suited to the inherently global and fungible nature of cryptographic tokens and creates the first of its kind of compliance complications.
The legislative initiative stems from long-running debates over the application of U.S. federal securities laws to crypto tokens and the difference between bitcoin, considered a non-security, and almost all other tokens. The United States 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” of investment contract as defined by the Howey test.
FIT21 attempts to codify this impractical test by dividing regulatory oversight of crypto spot markets between the Commodity Futures Trading Commission (CFTC) and the SEC, based on, among other things, the degree of decentralization.
While the bill appears to helpfully clarify that crypto tokens transferred or sold as part of an investment contract do not inherently become securities themselves, it unfortunately contradicts itself by nevertheless giving the SEC plenary authority on investment contract assets when sold to investors (or issued to developers). ) for the period before a project reaches decentralized Valhalla. Only tokens dropped or earned by end users are initially “digital products” subject to CFTC jurisdiction.
Most disconcerting is that FIT21 allows the simultaneous trading of restricted digital assets and digital products 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 United States indefinitely.
The bill’s proposed bifurcated market for restricted and unrestricted digital assets ignores fungibility as a fundamental characteristic of crypto tokens. By creating categories of restricted and unrestricted assets, the bill disrupts 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 crypto tokens, and ultimately stifle innovation in a nascent industry.
Implementing such distinctions would likely require technological changes to crypto tokens to allow buyers to know what type of crypto asset they are receiving so they can comply with specific market requirements. Imposing such technological marking on restricted digital assets, even if possible, would create a “US-only” crypto market separate from global digital asset markets, thereby reducing the utility and value of each affected project.
As shown in the chart above, tokens can transition between the SEC and CFTC markets in the event of recentralization of decentralized projects. The complexity and compliance costs created by such a system applied to thousands of future crypto tokens are significantly underestimated and would harm the credibility and predictability of U.S. financial markets. There are precious few examples of financial products passing between SEC and CFTC jurisdiction and it is almost always a tire fire (For examplethe 2020 transition of KOSPI 200 futures contracts from CFTC jurisdiction to CFTC/SEC joint jurisdiction).
The bill further underestimates the international nature of crypto token markets. Crypto tokens are global assets that trade as the same instrument globally. Attempting to restrict certain assets in the United States would likely lead to regulatory arbitrage, where the return of international markets would undermine the intent of the bill while eroding the competitiveness of the U.S. crypto industry.
Developers and investors outside the United States are unlikely to self-impose similar restrictions on restricted digital assets. Therefore, new projects and investors will be incentivized to move their development and investments outside the United States to avoid these requirements. This would make it extremely difficult to prevent the U.S. digital commodities market from being flooded with non-U.S. tokens that would have been restricted digital assets if “issued” in the United States.
Finally, and ironically, the bill intended to protect American consumers may end up harming them due to poor market structure. The first CFTC-regulated marketplaces for end-users will be filled with sellers who typically received tokens for free. These unbalanced market dynamics will most likely result in lower prices and increased volatility relative to small and international markets, with professional arbitrageurs benefiting at the expense of the US retail trade.
This system will further be exploited by insiders and professional investors, as arbitrageurs capitalize on disjointed prices and price-rise discontinuities 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.
Although FIT21 is a crucial step in 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 should refine the bill to unify spot markets for fungible crypto tokens that are not otherwise securities under a consistent regulatory framework .