The Breakdown - The Most Important Crypto Bill of 2023

Episode Date: June 5, 2023

On Friday, the chairs of the House Financial Services Committee and the Agriculture Committee shared draft legislation that is meant to comprehensively deal with the thorniest issues of crypto regulation, including securities-commodities designation. NLW gives a 101 on what the bill says, and what comes next.  Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribeto the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. What's going on, guys? It is Monday, June 5th, and today we are talking about the biggest crypto bill of the year. Before we get into that, a quick note. If you haven't checked it out yet, I would highly encourage you to go listen to Bitcoin Builders. It's a new show from the Breakdown Network that's all about the incredible creative and entrepreneurial energy that is surrounding Bitcoin, right? right now. I just published an interview with Robert Leashman from River. Before that, there was an interview with Obie from Fetty. And coming up, there's a really great overview and primer on Noster.

Again, the name of that show is Bitcoin Builders, and you can find out more at breakdown.network. Now, today, however, we have some actually interesting news in the crypto space. Frankly, friends, it has been a bit of a news desert. Now, on the one hand, that's pretty natural for this part of the cycle. The blockchain associations Jake Trevinsky recently wrote, it's crazy how much the mood in crypto feels like 2019 right now. Of course, many things are different in 2023, and nobody knows what the future will bring. But if market cycles are real, then now's a good time to start paying a little extra attention. Now that said, at the very end of last week and coming into this week, the news is starting to come fast and furious.

Today's show is going to be all about this big crypto legislation that was introduced at the very end of last week after we had finished taping shows for the weekend. And even as I record this, we just got news that the SEC was suing CZ and Binance. So obviously we know what tomorrow's show will be all about. But for today, I learned about this new legislation at 8.31 p.m. on Friday night. When Paradigms Justin Slaughter wrote, It's Friday night, the kids are in bed, the biggest piece of crypto legislation for this year has dropped. The McHenry-Thompson bill on market structure.

So let's get this party started. So on Friday, a new crypto draft bill was. released in collaboration between the House Financial Services Committee and the House Agriculture Committee. Called the Digital Asset Market Structure Discussion Draft, the bill takes a comprehensive look at current issues in crypto markets and seeks to set clear rules to address them. The bill was co-released by the Republican leaders of the two relevant committees, Patrick McHenry and Glenn Thompson, and aims to flesh out negotiations between the two parties on getting crypto legislation done. According to congressional staff, the bill is explicitly intended to

advance talks by making the Republican position clear, with a view to getting laws on the books by the end of this year. In that framework, the bill does not represent a firm stance on any particular issue, but rather a proposed starting point for compromise and refinement. No formal response has been put by Democrats at this early stage, but staff are reportedly reaching out to key party members to open dialogue and encourage the drafting of a reply bill to represent the Democrat position. Discussions have also begun with senators for both parties. Senator Cynthia Lummus, over the weekend that her bipartisan crypto bill, co-sponsored by Democrat Senator Kirsten Gillibrand, would be put on pause to see what comes of this new discussion draft. Now, the bill clocks in at a

hefty 162 pages, which for reference is around 20% of the size of the Goliath Dodd-Frank Act, which reformed the U.S. financial system in 2010. The bill covers topics ranging from how exchanges can be registered to custodian requirements, and of course the largest topic in U.S. crypto policy, which crypto assets should be defined as securities as opposed to commodities. Now, before we dive in, a quick special thanks to both Paradigms Policy Director Justin Slaughter and the other crypto legal minds who spent the weekend pouring through the bill and summarizing the legislation for the rest of us. Justin, for example, put together a 200-tweet thread summarizing the legislation.

Now, the bill begins with a large definition section. Of course, one of the most contentious issues in U.S. crypto regulation over the years has surrounded whether crypto assets should be considered securities and how a token could transition to being considered a commodity through a process of decentralization. The bill tackles this issue by assuming that tokens generally begin as securities through some kind of token sale and then decentralized in both ownership and governance over time becoming a commodity. To be considered decentralized, a token must have less than 20% ownership held by the token issuer or related parties. Governance must also be distributed with the team and related parties retaining less than 20% of the control over the protocol.

Now, these details aren't exactly the same as the way that the Lummis-Jillibrand Responsible Financial Innovation Act from last year dealt with this issue, but it does harken back to that in the sense that these tokens are not necessarily a security or a commodity, but go through a life cycle in which they can be both at different times. Now, back to this particular bill, the SEC would be given the authority to decide when a token had become sufficiently decentralized to be considered a commodity. Rather than granting the SEC broad veto power over a token's definition, the drafting of the bill would ensure that the matter is decided quickly and transparently. After a network applies for certification that they have become decentralized, the SEC would have just 30 days to respond with detailed analysis on any rejection of an application.

After that, there's the possibility of a public comment period and a court challenge to SEC decisions. Once a network has been certified as sufficiently decentralized, it would be granted an exemption from securities laws and treated as a commodity. Now, a big part of the reason that some have pushed for crypto assets to be defined, as securities is the need for a disclosure regime which isn't currently present in commodity markets. Of course, industry figures have pushed back at this assertion, arguing that the blockchain itself can provide much of the necessary information to any investor. So in this case, the bill acknowledges that securities disclosures are not suitable for crypto assets and instead establishes

a separate disclosure regime that is more designed for the particulars of this space. Under the bill, token issuers would be required to disclose their source code, provide a description of how to check the transaction history of the blockchain, including enough information to create a tool to verify that transaction history, describe the tokenomics, including launch distribution and ongoing supply, provide a development plan and identify the team responsible, and describe all material risks for the project. These disclosures are required to be updated with every material change and certified every six months.

Now, given that it will be difficult to provide this certification if the network is decentralized and the founding team is out of the picture, exchanges are empowered, to provide that certification. In addition to meticulously describing what makes a crypto token decentralized enough to be considered a commodity, the bill also provides a carve-out for stable coins, clarifying that they are not classified as securities. Now, what about the regulation of intermediaries? First, let's talk about the SEC.

Crypto exchanges will be able to register with the SEC as ATS's or alternative trading systems. This type of registration typically has looser regulation compared to registering as a securities exchange, but also allows for different market structures and procedures rather than requiring an exchange to conform to traditional rules. Essentially, this would give crypto exchanges a little latitude to operate in a way that suits crypto assets rather than conforming to rules designed for stock markets. Now, under this regime, registration with the SEC could not be denied simply because an exchange offers digital assets. This might seem like an obvious point to make, but multiple regulators have used the simple presence of digital assets as a reason to refuse licensing

in the past, so it's good to have it spelled out in black and white. The bill would also require the SEC to modify its rules to allow broker dealers to custody digital assets. Again, this might seem fairly common sense that a firm conducting trades in digital assets should also be able to allow to custody them on behalf of customers, but this issue was the subject of recent SEC rulemaking that threatened to remove access to major exchanges from financial advisors. Now, when it comes to the CFTC, a huge portion of the bill is dedicated to establishing a new regulatory framework for entities it calls digital commodities exchanges. The framework shares a lot of features that already exist under the Commodity Exchange Act and duplicates most of the conduct

requirements for exchanges. That includes things like a requirement to monitor markets, prohibition of market manipulation, and rules around conflicts of interest. As part of this, exchanges would be required to join existing industry associations which provide oversight, which generally will mean getting registered with the financial industry regulatory authority or FINRA. Broadly, this means that crypto exchanges will have their own registration category that brings their standards up to the requirements across the broader financial industry. A new category is necessary mainly because it means that exchanges are clearly required to register, even though crypto assets are not yet formally defined as commodities or securities. The other big reason to clearly define this area

is that the bill provides clarity that the CFTC has oversight over spot markets for crypto commodities. Currently, there is no regulator with the authority to set rules for spot markets in commodities like Bitcoin and Ethereum, with the CFTC limited to enforcement against fraud and manipulation rather than being allowed to make proactive rules. Exchanges would be able to apply for provisional registration, essentially allowing markets to continue operating during the transition. This means that exchanges have a pathway to come into compliance straightaway, while the CFTC is nailing down the details of rulemaking.

It also means that applying for provisional registration would prevent the SEC from pursuing enforcement action related to listing tokens as commodities rather than securities, or either regulator from suing for failure to register. As Justin Slaughter again puts it, that's a BFD. Now, the listing requirements for crypto commodities are fairly permissive. Exchanges would simply be required to certify that an asset is not susceptible to manipulation before listing. Generally, the requirements of exchanges would be tightened up with standards around governance, conflicts of interest, and capital requirements in a similar manner to those in place for firms operating in Tradfai markets. Now, when it comes to regulatory coordination, exchanges would be

enabled to register with both the SEC and the CFDC to ensure they can offer trading for both commodity tokens and security tokens. This was a long-standing concern with the common and register rhetoric from the SEC, as obtaining a license to operate a securities exchange currently prohibits hosting commodities trading on the same platform. This separation makes sense when it comes to such disparate markets as stocks and oil futures, but when seeking securities exchange registration would, for example, eliminate an exchange's Bitcoin trading. Given that, it's little wonder exchanges have been unenthusiastic to try to get licenses. Crypto firms are likewise allowed to register as offering multiple types of services that are typically separated under current securities law.

For example, an exchange could also register as a custodian. The only prohibition is on registering as both an exchange and a dealer, functionally banning exchanges from operating their own in-house marketmaker or prop trading firm. The SEC and CFTC are also, through this legislation, instructed to make this dual registration work, which means eliminating contradictory rules. rules. This would resolve another long-standing issue for crypto firms that the rules of one regulator sometimes require breaking the rules of the other. Now, as exchanges would be legally allowed to custody client assets under this regime, the co-mingling of customer funds also needed to be dealt with. Per this legislation, crypto custodians are required to segregate customer funds, but this can

simply be an accounting separation. This deals with an industry concern around custody best practice. While the losses related to co-mingling of customer funds have been catastrophic over the last year, that doesn't necessarily mean that maintaining a separate crypto wallet for every customer is an appropriate security setup. In fact, the failure of that setup was a large part of the Bitfinex hack in 2016. Instead, custodians are simply required to properly account for customer assets, but not required to store them using separate private keys. As a corollary to this consumer protection measure, client funds will be considered separate to accompany's assets during bankruptcy. This has been a massive legal issue over the last year, that many in the industry have pointed out could easily be

changed with legislation. Now, overall, the tone of the bill is that both the SEC and the CFTC need to get on with the rulemaking and stop squabbling over resources. Some parts of the crypto industry are allocated to each regulator where appropriate, but overall the idea is that both regulators need to collaborate on dealing with an asset class that straddles their jurisdictions. There's enough clarity to keep each regulator in their lane, but also an emphasis on the idea that a workable regulatory framework needs to come out of this process without contradictory rules being enforced. Now, there's a lot that I haven't even had a chance to cover here. Again, this thing is over 160 pages long. For example, the bill considers airdrops and opens the door for them to be used in the U.S. once again

by providing a limited exemption from securities laws, as long as there isn't any investment contract involved. NFTs and DFI are specifically not considered, but the bill requires studies to be conducted on these policy areas. Dow's are mentioned and defined, but the bill mainly does this in order to make it clear that DAOs which offer services that require registration are not exempt. This could cause some problems for DAOs that offer services like derivatives trading, but at least there should be a path to register that kind of DAW. Now when it comes to bringing this thing online, the bill provides a pathway for both exchanges and token issuers to come into compliance straightaway while the details are worked out by regulators. For exchanges, this just

requires registration and the provision of fairly reasonable risk disclosures to customers alongside description of the assets being offered. For existing tokens, the moratorium is even more broad. Tokens will be allowed to continue trading until either the SEC or the CFTC issues and notice that the token is considered a security, kicking off that process. Functionally, this isn't massively different to the process currently. Tokens that are considered commodities by the exchanges generally trade until the SEC launches an enforcement action. However, legally, this makes a huge difference. Exchanges will be given the benefit of the doubt when offering assets on their platforms and won't have to live in fear of a notice from the SEC for offering unregistered securities. This would hopefully

put a stop to the creeping SEC tactic of governing the industry by going after the exchanges, rather than simply providing them with notice to delist and pursuing enforcement against the token issuers. Now, taking a step back and getting a little bit of context, Gabriel Shapiro at Lexnow, the General Counsel at Delphi Digital, says, we need to step back and realize what this bill is trying to do. Unlike the EU's MECA, it is not a let's figure out how to regulate crypto from scratch, from first principles kind of thing. Instead, it meets the existing U.S. regulatory landscape where it lives, while seeking to harmonize crypto within it by enabling tokens and related intermediaries to be simultaneously regulated by the CFTC and the SEC in different ways. The result is complicated,

confusing, risky, and frustrating, but also a good faith, diligent, informed effort to make crypto work on its own terms within the U.S.'s incredibly Byzantine and otherwise incompatible financial regulatory environment. It's probably our best hope. Justin Slaughter writes, very rare to see two chairs collaborate like this. In fact, it basically only happens for very marquee legislation. Usually, when a topic crosses into the jurisdiction of multiple committees, each committee works on their own topic and then the text is then combined. The biggest issue is that this is an all-GOP bill. So this bill may pass the House, but it will need some serious Democratic support, likely 50 to 100 Democratic House members, to have a chance of becoming law.

Now, Gabriel Shapiro also did another long thread pointing out the ways in which any regulation is likely to create its own new set of behaviors, even if unintentional. For example, he writes, a key challenge with this market structure bill will be explaining to legislators that every idea they bake in about what blockchains, decentralization, etc., are supposed to look like, are setting an incentive for them to be designed that way, and not always for the better. For example, a decentralized network is not SEC regulated, but to have your system be considered a decentralized network, you must not contribute to the co-base for three months. Why incentivize this? What if there is a big security issue. It doesn't really make sense because if the other prongs of

decentralization are met, then the devs do not control whether this new software is adopted, so what's the harm in them creating it and publishing it for potential adoption? Similar issue with the three-month ban on marketing. Seems like the issuer can go right back to marketing again after getting the sufficient decentralization certification. So what's the point of stopping the marketing, then letting it resume? What policy goal is served? Now closing out with Justin Slaughter again, here's how he sums things up. The main outstanding questions I have are, what part of this bill applies directly to defy? Can a network be deemed decentralized at launch? How will House Democrats and Congress respond to it?

They weren't that involved in drafting it. Now, it's clear that this bill won't clear 60 votes in the Senate in its current form. So this bill is probably lighter touch than can actually become law this Congress. This is almost certainly the bill with the best chance of becoming law before the 2024 presidential election scrambles the board. Even in its current form, it's not everything the industry wants. and the SEC will likely oppose it as they are now opposing all legislation. So we all face a time of choosing. For the industry, Congress, and regulators. This bill will have a tough path to become law, as all bills do.

2025 may result in a more favorable Congress to crypto, of course, but elections are always uncertain. Democrats should also be thinking that this may be their best chance to legislate on crypto. If courts do find against key agencies in some cases, this bill may end up being far tougher than anything that could pass into law in the next decade. Overall, the McHenry Thompson bill is a strong effort at crafting a comprehensive regulatory regime for crypto. All right, guys, so that is our kickoff of our coverage on this bill. There are exactly two types of legislation that get introduced in the U.S., legislation that never

has any intent of going anywhere, and is really just meant for a politician to state their claim in a particular area, to plant their flag, and then legislation that people actually want to pass in some form or another. The vast, vast majority of the bills that we see that relate to the bill that we see that relate to crypto, even from our allies, are flag planters, our waymarkers of key issues. This one doesn't feel like that. This one feels like a thing that they actually want past. One of the things that I'll be watching is to see how Lummis and Jillabrand in the Senate pick up the mantle here. Will they combine this with their Responsible Financial Innovation Act in some way? And of course, we still need to see what the

first response from Democrats will be. It's hard to identify exactly the areas that they might have issues with. But all of that is likely to arrive in the weeks to come. So for now, thanks again to Justin Slaughter, to Gabriel Shapiro, and to all the legal minds who are helping us interpret all this stuff. Thanks to you guys for listening. And until tomorrow, be safe and take care of each other. Peace.