Getting CLARITY on Crypto Market Structure

A crib sheet (and some deeper thoughts) on the House's latest crypto bill.

A new regulated asset class: Digital Commodities

Who/what will regulate Digital Commodities?

The CFTC oversees digital commodities, but the SEC will continue to regulate the offer and sale of investment contracts involving digital commodities.

What are Digital Commodities?

The term is comprised of three elements:

• a digital asset
• intrinsically linked to a blockchain system,
• the value of which is derived from or is reasonably expected to be derived from the use of the blockchain system.

What is a Digital Asset?

All on chain assets are digital by definition. At the risk of stating the obvious, however, it should be noted that, to the extent a token represents a claim against another asset, while the token itself may qualify as a digital commodity, the underlying asset may or may not. In fact, digital assets that represent a number of enumerated off chain assets are specifically excepted from the definition of a digital commodity (more on these exceptions below).

When is a digital asset “intrinsically linked” to a blockchain system?

Per Sec 103(a)(4) the token must be “directly related to the functionality or operation of the blockchain system or to the activities or services for which the blockchain system is created or utilized.”

Proposed codified examples of intrinsic linkage include:

• the token is minted by the programmatic functioning of the blockchain system;
• the token is used to transfer value between blockchain network participants;
• the token is burned, consumed or otherwise used to access the activities or services of the network;
• the token is used to participate in the decentralized governance system of the blockchain system;
• the token is used or removed from circulation in whole or in part to pay fees or otherwise verify or validate transactions on the network;
• the token is used as payment or incentive to participants in the blockchain system to engage in the activities of the blockchain system, provide services to other participants in the blockchain system, or otherwise participate in the functionality of the blockchain system; or
• the token is used as payment or incentive to participants in the blockchain system to validate transactions, secure the blockchain system, provide computational services, maintain or distribute information, or otherwise participate in the operations of the blockchain system.

Must a digital asset be the native token in relation to its blockchain system to qualify as a digital commodity?

I have seen at least one review comment that the bill may be interpreted as applying digital commodity status only to tokens native to their own blockchain system. I do not hold this view. I agree that the use of phrase “directly related to the functionality or operation of the blockchain system” seems to refer to native token status, but the phrase goes on to say “(directly related to)…the activities or services for which the blockchain system is created or utilized” which suggests (to me, at least) that a token need not be native. This is confirmed by some of the specifically enumerated examples of intrinsic linkage (e.g. “a token used to transfer value between blockchain participants”).

Additionally, the definition of “blockchain system” extends beyond protocols and includes blockchain applications (which may or may not be protocols) along with networks of blockchain applications.

Are there any codified exclusions to digital commodities?

Yes. The term ‘digital commodity’ does not include any of the following:

• securities (but note the important exception for decentralized governance systems below)
• security derivatives
• permitted payment stablecoins
• banking deposits
• commodities (i.e. digital assets that reference a regulated commodity or commodity derivative)
• pooled investment vehicles (see note below).
• goods, collectibles, and other non-commodity assets (see note below).

Relevance of exclusion for securities (and re-inclusion of decentralized securities)

The securities exception to the definition of a digital commodity “un-excepts” and reinserts back into the definition of a digital commodity any token that represents a note, an investment contract, or a certificate of interest or participation in any profit- sharing agreement that represents or gives the holder an ownership interest or other interest in the revenues, profits, obligations, debts, assets, or assets or debts to be acquired of a decentralized governance system.

In other words, tokens that deliver on chain economic rights and which would otherwise be deemed securities are not so and are instead digital commodities where such tokens represent an interest in a decentralized governance system.

The bill defines decentralized governance system, with respect to a blockchain system, to mean any:

• transparent
• rules-based system
• that allows persons to form consensus or reach agreement in the development, provision, publication, management, or administration of such blockchain system,
• where participation is not limited to, or under the effective control of, any person or group of persons under common control.

If this exception survives, I suspect considerable industry mindshare will be deployed to address the issue of what effective control means, not just from a guidance and rulemaking perspective, but also from the point of view of front-line practitioners. The ability to issue decentralized securities without registration will likely drive massive opportunities for decentralized offerings and holders. Legal advisors will need to consider the impact of delegation and quorum rules, as well as become better versed in anti-concentration tactics including compulsory vote dilution/anti-accumulation terms along with vote weighting and access measures.

The “distributed ownership” requirement relating to maturity certification for blockchain systems references a beneficial ownership concentration limit of 20%, and therefore some may use 20% as a proxy, but I would point out that the use of “effective control” rather than a hard and fast UBO cap in the definition of decentralized governance system suggest that the legal analysis will likely need to be more nuanced for counsel seeking to advise clients around decentralization.

Relevance of exclusion for pooled investment vehicles

Specifically, the seventh enumerated exception to digital commodities is bifurcated into to tokens that represent, or are functionally equivalent to: (i) a commodity pool, as defined in the CEA; or (ii) an investment company, as defined in the 1940 Act. Picking knits, I believe what the language intends to say is that tokens that represent an interest in a pool or investment company (rather than representing the pool or IC, itself) are exempt from classification as a digital commodity.

On its face, the exclusion for interests in an investment company seems superfluous since participation interests in an investment company are inherently securities, and as such would already be exempt from digital commodity classification. Thinking deeper on the matter however, it is apparent that this exclusion may have two potentially significant impacts in application.

First, interests in a decentralized governance system that also qualifies as an investment company would be exempt from classification as a digital commodity. More specifically, in analyzing such an interest it would be:

a security (investment contract) → a digital commodity (excepted decentralized security) → back to a security (interest in a pooled investment vehicle) .

The intent appears clear to limit the application of the US securities frame work in connection with decentralized securities. But it is unclear (to me) whether that limitation stops at the 40 Act. Add to this uncertainty the question of whether a decentralized governance system is even intended to qualify as a “person” at all, for purposes of determining issuer status. Section 2(a)(22) of the 40 Act defines the term “issuer” to mean “every person who issues or proposes to issue any security, or has outstanding any security which it has issued.” Section 205 of the bill amends the Exchange Act by adding a new Section 42 related to certification of mature blockchain systems which states in part, “[f]or the purposes of this section, a decentralized governance system is not a ‘person’ or a ‘group of persons under common control’.” A literal reading suggests to me that a decentralized governance system is not a person for purposes of consideration of blockchain maturity criteria, but may be a person for purposes of issuer status. Given the express maturity carve out from personhood and the very clear intent to limit application of parts of the Securities Acts to decentralized securities, however, I am not certain. The answer may tick and tie to a different portion of the bill in a way I am not seeing, but if not, further specificity would be ideal.

Second, with respect to RWA projects, specifically conduit-like tokenized SPVs at risk of being deemed an investment company, tokens can be deployed to act not as a direct interest in a pooled investment, but rather as an instruction to an off chain broker-dealer or custodian in relation to the holder’s interest or prospective interest in the pooled investment. It is unclear, here, whether the legislative intent is to render the on chain instruction token analogous to the off chain participation interest such that buying/selling of the token, itself, amounts to a securities transaction.

Relevance of exclusion for non-commodity assets

Tokens referencing the following off chain assets are excluded from the definition of digital commodity:

• works of art, musical compositions, literary works, or other intellectual property;
• collectibles, merchandise, virtual land, and video game assets;
• affinity, rewards, or loyalty points, including airline miles or credit card points, that are not primarily speculative in nature; or
• rights, licenses, and tickets.

The impact of this exclusion is twofold: (i) the NFTs and fungible tokens representing fractionalized interests in these non-commodity assets are still susceptible to being deemed securities and (ii) the underlying assets remain subject to regulation of existing frameworks (e.g., loyalty points will not be subject to CFTC jurisdiction merely due to tokenization, but rather will remain subject to FTC and CFPB oversight).

No presumptions in favor of security status

Cementing the intent to shift oversight of crypto assets from the SEC to the CFTC the act provides that “[n]o presumption shall exist that a digital asset is a security, nor shall a digital asset be excluded from being a digital commodity pursuant to clause (iii) solely due to:”

• the token providing voting or economic rights
• the value of the token having the potential to appreciate or depreciate in response to the efforts, operations, or financial performance of the decentralized governance system of the blockchain system to which the digital asset relates; or
• the value of the digital asset appreciating or depreciating due to the adoption and use of the blockchain system to which the digital asset relates or the decentralized governance system of the blockchain system.

Rulemakings

Mixed digital asset transactions

The bill requires the SEC and CFTC to engage in joint rulemaking with respect to transactions that involve the trading of a digital commodity for a security.

Self custody protections

The bill declares that “United States individual(s)” shall retain certain rights with respect to crypto. Namely, the right to self-custody via hardware or software wallets and the right to engage in P2P transactions.

While these protections have generally been met with applause in social media circles, my reaction is a bit more reserved. While I do not fault the spirit of the declaration, the wording is weirdly circular- I have the right to maintain a wallet for lawful custody of digital assets… so I have an absolute right to maintain a wallet. And I can custody digital assets in that wallet, provided the government agrees said custody is lawful.

As an aside, I do not know who or what a “United States individual” is. Is it a US citizen? A US resident? Merely someone passing through on a connecting flight, accessing wifi via a US-based IP address? Does it include persons here without the consent of the US government?

Offers and sales of digital commodities

Primary sales of digital commodities

The bill creates a new exemption (new Section 4(a)(8) of the 33 Act) from registration of securities under Section 5 for public sales of tokens by an issuer to US purchasers where all of the following requirements are met:

• the token is a digital commodity;
• the blockchain system to which the token relates is certified as a “mature blockchain system” (more on maturity below) or the issuer intends the blockchain system to be mature within the later of: (i) four years from first primary sale or (ii) four years from the bill going into effect;
• the amount of the primary offering during any 12 month period is not more than $75million;
• after the completion of the offering, a purchaser does not own more than 10 percent of the total amount of the outstanding units of the digital commodity;
• the issuer must be organized under the laws of a State, a territory of the United States, or the District of Columbia;
• the issuer is not:
  • a "development stage company” with no “specific business plan or purpose”; or a SPAC;
  • an investment company, as defined in 40 Act “or is excluded from the definition of investment company by section 3(b) or section 3(c) of that Act”
  • issuing fractional undivided interests in oil or gas rights, or a similar interest in other mineral rights; ‘
  • or has not been, subject to any order of the SEC entered pursuant to section 12(j) of the 34 Act during the 5-year period before the filing of the offering statement; or
  • is disqualified pursuant to the “bad actor” rules; and
• the issuer provides the disclosures required under the new Section 4B(b) of the 33 Act.

Commodity Issuer disclosure requirements

A digital commodity issuer offering or selling an investment contract involving units of a digital commodity in reliance on section 4(a)(8) must file with the SEC an “offering statement and any related documents, in such form and with such content as prescribed by the Commission” to include:

• maturity status;
• source code;
• transaction history- specifically the steps necessary to access, search, and verification activities (to the extent technically feasible) of any blockchain system to which the digital commodity relates;
• digital commodity economics, to include:
  • information explaining the launch and supply process, including the number of units of the digital commodity to be issued in an initial allocation, the total number of units of the digital commodity to be created, the release schedule for the units of the digital commodity, and the total number of units of the digital commodity outstanding;
  • information explaining the technical requirements for holding, accessing, and transferring the digital commodity;
  • information on any applicable consensus mechanism or process for validating transactions, method of generating or mining digital commodities, and any process for burning or destroying units of the digital commodity on the blockchain system;
  • an explanation of any mechanism for driving value to the digital commodity of such blockchain system; and
  • an explanation of governance mechanisms for implementing changes to the blockchain system or forming consensus among holders of units of such digital commodity.
• plan of development;
• ownership disclosures; and
• risk factor disclosures.

Additionally, ongoing issuer reporting requirements are detailed in the bill, along with post-maturity reporting requirements and conditions causing the termination of reporting obligations.

Thoughts re primary sale exemption requirements: US-organized Issuer

The US-organization requirement raises a couple of interesting issues:

• first, the typical Reg S cat 1 FPI playbook of using a Cayman foundation-owned BVI issuer(or a Panamanian foundation or Swiss association) will likely lose appeal for US-based projects that can qualify for the 4(a)(8) exemption and are seeking to access the US market; and
• The question of “which entity?” will dominate the discussion for US crypto TGE lawyers. Corporations will not be an option. DUNAs (and UNA’s generally) may work for more centralized issuers and decentralized governance systems not seeking to deliver rights of cashflow to holders. But networks looking to take advantage of the decentralized governance system exception to the securities exception to the definition of a digital commodity (need to develop a shorthand for this exception-to-the exception) will be limited to perhaps member-managed LLCs and potentially co-ops and/or trusts under very niche scenarios. LLC design, especially member-managed permissionless entities at scale may present numerous drafting and structuring traps for the uninitiated.

Thoughts re primary sale exemption requirements: 40 Act Intersection

To clarify, not only are issuers meeting the definition of an investment company unable to avail themselves of the 4(a)(8) exemption, but issuers otherwise excluded from the definition of an investment per sections 3(c)(1) or 3(c)(7) and (perhaps most concerning) 3(b) (i.e. operating companies not primarily engaged in investment activities) of the 40 Act are also not permitted to invoke the primary sale exemption.

Are airdrops addressed?

Yes. Airdrops (“End User Distributions”) are not securities transactions provided:

• the drop is of a unit of a digital commodity
• the drop does not involve an exchange of more than a nominal value of cash, property, or other assets; and
• The drop is distributed in a broad and equitable manner based on conditions capable of being satisfied by any participant in the blockchain system, including, as various incentive-based rewards.

What is is a “mature” blockchain system?

A blockchain system is “deemed mature” where the blockchain system, together with its related digital commodity, is not controlled by any person or group of persons under common control, and one of the two following conditions are met:

1. Criteria for all blockchain systems- satisfaction of conditions relating to:
   1. MARKET VALUE. The digital commodity has a value that is substantially derived from the adoption, use, and functioning of the blockchain system.
   2. DEVELOPMENT OF VALUE MECHANISM SUBSTANTIALLY COMPLETED. Where the digital commodity issuer has made public a development plan describing how the digital commodity’s value is reasonably expected to be derived from the programmatic functioning of the blockchain system, the development of such mechanisms has been substantially completed.
   3. FUNCTIONAL SYSTEM. The blockchain system allows network participants to engage in the activities the blockchain system is intended to provide, including:
      1. using, transmitting, or storing value, or otherwise executing transactions, on the blockchain system;
      2. deploying, executing, or accessing software or services, or otherwise offering or participating in services, deployed on or integrated with the blockchain system;
      3. participating in the consensus mechanism, transaction validation process, or decentralized governance system of the blockchain system; or
      4. operating any client, node, validator, sequencer, or other form of computational infrastructure with respect to the blockchain system.
   4. OPEN AND INTEROPERABLE SYSTEM. The blockchain system:
      1. is composed of source code that is open source; and
      2. does not restrict or prohibit based on the exercise of unilateral authority any person, other than a digital commodity issuer, digital commodity related person, or a digital commodity affiliated person from engaging in the activities the blockchain system is intended to provide.
   5. PROGRAMMATIC SYSTEM. The blockchain system operates, executes, and enforces its operations and transactions based solely on pre-established, transparent rules coded directly within the source code of the blockchain system.
   6. SYSTEM GOVERNANCE. No person or group of persons under common control:
      1. has the unilateral authority, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise, to control or materially alter the functionality, operation, or rules of consensus or agreement of the blockchain system or its related digital commodity; or
      2. has the unilateral authority to direct the voting, in the aggregate, of 20 percent or more of the outstanding voting power of such blockchain system by means of a related digital commodity, nodes or validators, a decentralized governance system, or otherwise, in a blockchain system which can be altered by a voting system.
   7. IMPARTIAL SYSTEM. No person or group of persons under common control possesses a unique permission or privilege to alter the functionality, operation, or rules of consensus or agreement of the blockchain system or its related digital commodity, unless such alteration:
      1. addresses errors, regular maintenance, or cybersecurity risks of the blockchain system that affect the programmatic functioning of the blockchain system; and
      2. is adopted through the consensus or agreement of a decentralized governance system.
   8. DISTRIBUTED OWNERSHIP. No digital commodity issuer, digital commodity related person, or digital commodity affiliated person beneficially owns, in the aggregate, 20 percent or more of the total amount of units of the digital commodity.
2. Optional criteria for preexisting blockchain systems.
   1. the blockchain system was created prior to the date of enactment of the bill;
   2. the blockchain system met the requirements of point 1a through1g above prior to January 1, 2020; and
   3. at least 50 percent of the units of the digital commodity related to the blockchain system are held by persons other than the digital commodity issuer, a digital commodity related person, or a digital commodity affiliated person.

Secondary Sales of Digital Commodities

The headline is that secondary sales of digital commodities are not treated as securities transactions, BUT the devil may be in the details. The bill provides that secondary sales are sales not involving “the issuer of such digital commodity, or an agent or underwriter thereof.” If a market maker is utilized by an issuer and is deemed a distribution agent or underwriter, then per the language of Sec. 203, sales of a digital commodity on an exchange by the market maker could be deemed an offer or sale of the investment contract involving the digital commodity.

The rest

This post only scratches the surface in terms of fully covering the bill. I am continuing to dig deeper, especially on intermediary treatment, affiliate and related party obligations, and maturity failure scenarios. What I can say thus far, however, is that I am somewhat surprised at how much better positioned this bill is from prior iterations, particularly with respect to defi (well, I can’t say I’m that surprised given all of the behind-the-scenes time and effort key industry leaders have put in on this).

It will be interesting to see the reception CLARITY receives, politically, and there will always be additional kinks to work out, but I am feeling much better about the direction of market structure legislation.