Securities or commodities? Analyzing the regulatory game of encryption assets in the US market

With the growing influence of blockchain digital assets in mainstream financial markets, their unique decentralized attributes have also brought challenges to the financial regulatory systems of various countries. How can the TradFi regulatory framework adapt to the uniqueness of blockchain digital assets? How to drop risks? The focus of controversy is also different.

Data from the Financial Action Task Force (FATF), an international Anti-Money Laundering regulatory body, shows that among 130 jurisdictions worldwide, 88 jurisdictions allow virtual asset service providers to operate, while 20 jurisdictions explicitly prohibit virtual asset services.

digital asset as a security

The United States is a jurisdiction that allows the provision of virtual asset services (including blockchain digital assets), and explicitly recognizes that virtual assets are not real currency. It adopts a joint regulatory model, and different businesses may be subject to different regulatory agencies. In the United States, the blockchain digital asset industry covers a variety of businesses, such as Wallet services, digital asset exchanges, ICO, mining, smart contracts, stake/re-stake services, Non-fungible Tokens, etc.

Therefore, due to the jurisdictional game, there is still controversy over the regulatory authority vesting of a batch of digital assets on the blockchain represented by ETH and with stake services. The focus of the controversy is whether such digital assets represented by ETH are commodities or securities. The Securities and Exchange Commission (commonly known as SEC) and the Commodity Futures Trading Commission (commonly known as CFTC) and other regulatory agencies have been actively involved in assessing the applicability of existing regulations, such as applying the howey test to determine whether digital assets belong to “investment contracts”, and if so, they are subject to securities regulation.

The Howey test originated from the case of Securities and Exchange Commission v. W.J. Howey Co. in 1946, which established a clear framework for the Securities and Exchange Commission to determine whether subsequent investment contracts should be regulated as securities based on specified criteria.

If the investment contract passes the howey test, it is considered a security. Taking ETH as an example, the key points of the test include:

• Does ETH involve financial investment?
• Does the user have profit expectations?
• Is there a form of investing in a Common Enterprise?
• Is the expectation of profit solely reliant on the efforts of the promoter or a third party?

The “Framework for ‘Investment Contract’ Analysis of Digital Assets” published by the Securities and Exchange Commission (SEC) of the United States on April 3, 2019, states that if you are considering conducting an ICO or participating in the issuance, sale, or distribution of digital assets in any other way, you need to consider whether the U.S. federal securities laws apply. A analysis of the digital asset should be conducted to determine if it has any characteristics that meet the definition of “securities” under federal securities laws. The term “securities” includes “investment contracts”, stocks, bonds, and other instruments that are transferable shares.

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For details on the analysis framework of whether virtual assets constitute investment contracts, please refer to the Securities and Exchange Commission’s document:

What will happen if digital asset is determined to be a security?

The Securities and Exchange Commission of the United States has jurisdiction over such digital asset. Common administrative enforcement methods of the Securities and Exchange Commission of the United States for violations of regulatory requirements include:

• The Securities and Exchange Commission (SEC) of the United States files civil lawsuits against companies, founders, and executives involved in blockchain digital asset-related businesses on grounds of violating U.S. securities laws, such as engaging in illegal activities like selling unregistered securities and failing to disclose key information to the public. The jurisdiction is determined by court rulings.
• The Securities and Exchange Commission of the United States imposes administrative penalties on companies, founders, and executives providing blockchain-related digital asset businesses for violating US securities laws (such as illegal acts of selling unregistered securities, failure to disclose key information to the public, etc.).

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The U.S. Securities and Exchange Commission Sues Ripple Case

In December 2020, the Securities and Exchange Commission (SEC) of the United States filed a lawsuit against Ripple and its co-founders, alleging that since 2013, Ripple and its co-founders have issued and sold the Ripple digital asset XRP in various ways in exchange for over billions of dollars. However, Ripple and its co-founders did not register the issuance of XRP assets with the SEC, nor did they qualify for an exemption from registration, which violated relevant provisions of the U.S. securities law.

In the first-instance judgment, the court judged whether the sale of XRP assets in different ways constituted a sale of “securities” based on the economic substance of the transaction. Finally, the court found that XRP’s financing in the PE Round for institutional professional investors met the detection standards of the howey test and constituted a sale of “securities”, while the sale of XRP in exchanges and other channels did not constitute a sale of “securities”. However, the US Securities and Exchange Commission subsequently filed an appeal, and the above court ruling is not yet final and binding.

digital asset as a commodity

In the United States, commodities are generally defined as basic goods used in commerce that can be exchanged for other similar goods. Common commodities include gold, oil, and agricultural products, etc. The Commodity Futures Trading Commission is responsible for regulating commodity trading, with a focus on ensuring market stability and preventing fraud.

Although digital assets on the Blockchain are not explicitly defined as commodities under the Commodity Exchange Act in the United States, the Commodity Futures Trading Commission (CFTC) first stated in a settlement order in 2015 that BTC and other digital assets are commodities within its jurisdiction. Subsequently, the CFTC expanded this classification to include other digital assets such as ETH, recognizing digital assets as commodities - they possess characteristics such as fungibility, market tradability, and a certain level of scarcity.

Limited digital asset vs. Digital goods

On May 22, 2024, the U.S. House of Representatives passed H.R. 4763, also known as the 21st Century Financial Technology Innovation Act (hereinafter referred to as the ‘FIT21 Act’).

Patrick McHenry, Chairman of the House Financial Services Committee, said that the FIT21 Act provides the necessary regulatory clarity and strong consumer protection measures for the prosperous development of the digital asset ecosystem in the United States.

Regarding the qualification issue of digital assets, the FIT21 Bill classifies digital assets into the following two types and clarifies regulatory responsibilities:

• Restricted digital asset regulated by the Securities and Exchange Commission (SEC) of the United States.
• “Digital commodities” regulated by the Commodity Futures Trading Commission.

And how to determine the type of digital asset is influenced by the following 3 factors:

• Has the underlying blockchain of this digital asset been certified as a “Decentralization system”?
• How were the assets acquired?
• Is the asset holder an affiliated company of the issuer or related to the issuer?

In addition, the FIT21 bill also requires certain participants in the digital asset field to comply with registration and disclosure requirements related to the blockchain system where the digital asset is located.

The Impact of Qualitative Digital Asset

Using ETH as an example, if ETH is classified as a security, it will fall under the jurisdiction of the Securities and Exchange Commission (SEC) in the United States. In addition to the requirement of registration issuance, service providers and asset management companies may also need to fulfill strict obligations of information disclosure, registration, and investor protection measures, resulting in significant compliance costs and potential loss of investment opportunities for retail investors, which may dampen market sentiment.

If ETH is classified as a commodity, it will be regulated by the Commodity Futures Trading Commission. This classification will not significantly increase Compliance costs and will promote the development of the ETH Derivatives market, but it cannot reflect the unique properties of Decentralizationdigital asset.

In addition, regulatory arbitrage between regulatory agencies such as the US Securities and Exchange Commission and the Commodity Futures Trading Commission may bring regulatory arbitrage, making the regulatory environment for Ethereum and other market participants more complex.