The 118th Congress is set on addressing the regulatory vacuum around digital assets. Its April 19 inaugural session on “payment stablecoins” was covered in part 1 of this series, which also explained what stablecoins are and their implications for the larger macroeconomic system. With the debt ceiling controversy behind us for now, a more constructive discussion about policy interventions needed for digital assets in the US financial system can take place. In this entry, we dive deeper into the definition of asset classes, why these definitions matter, and describe a regulatory solution proposed by the former chair of the Commodity Futures Trading Commission (CFTC).
Asset classes: securities vs. commodities
The classification of digital assets as securities or commodities lies at the center of a broad partisan divide in Congress and is manifested in an ongoing tug-of-war between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) over how to deal with crypto.
The SEC and the CFTC are the two agencies responsible for overseeing and regulating securities and commodities as well as ensuring the proper functioning of financial markets. However, determining whether a digital asset falls under the definition of security or a commodity is proving to be a complex task, especially as conflicting interpretations have emerged between regulators and the crypto industry. This SEC and CFTC find themselves at odds when it comes to the classification of digital assets, with most of the attention centering around Bitcoin, Ethereum, and stablecoins.1
Last month, the CFTC brought an enforcement action against the trading platform Binance, asserting that Binance’s BUSD stablecoin is a commodity. Separately, the SEC also pursued Binance and asserted that the same stablecoin is a security. In its complaint, the CFTC referred to Bitcoin, Ether, and Litecoin as commodities. In contrast, SEC Chair Gary Gensler stated that he considers all digital assets other than Bitcoin to be securities, and pursued the crypto industry en masse, including Binance and Coinbase, for violating securities law. These conflicting positions demonstrate the urgent need for a consistent solution lest the crypto industry seek recourse in Europe.2
Commodities refer to assets that fall under the definition of commodities in the 1936 Commodity Exchange Act. Commodities are traditionally tangible goods or raw materials that can be bought, sold, or traded, such as agricultural products (e.g., corn, cattle), energy resources (e.g., oil, natural gas), or precious metals (e.g., gold, silver). Commodities are not necessarily restricted to consumption or industrial goods. Works of art and real estate, for example, can serve as investment commodities. It has proven useful to keep the definition of what constitutes a commodity broad to account for changing societal and technological conditions. That way, a wide range of assets can be regulated as commodities as long as their ownership constitutes an investment in the commodity itself and not in the efforts of those involved in producing it. A commodity’s price is typically derived from its intrinsic value and supply-demand dynamics.
Commodities are traded in the spot market and through futures contracts, allowing investors to speculate on the future price movements of these goods. The CFTC sets rules and enforces compliance for the proper conduct of futures and options trades, but cannot interfere in the free market pricing of how commodities are bought and sold. In the context of digital assets, the term “digital commodity” describes certain cryptocurrencies or tokens, typically Bitcoin, that exhibit characteristics similar to traditional commodities.
Securities refer to financial instruments that represent debt obligations or ownership in a company with the expectation to receive future returns. Intuitively, whenever an expectation of future profit can be made, the financial instrument in question is a security. Securities can take various forms, such as stocks, bonds, investment contracts, or derivatives. They are typically issued and traded in capital markets, enabling public companies to raise funds from investors and fall under the regulatory purview of the SEC in the United States. In the context of digital assets, “digital securities” or “security tokens” are the digital equivalent of traditional securities. These tokens may carry the same characteristics and rights as traditional securities, including ownership, dividends, or voting rights in a company.
The prevailing consensus today is that Bitcoin is a commodity while Ethereum remains the subject of much debate because it straddles both definitions.
The Classification Dilemma and the Howey Test
Regulatory design decisions are a complicated political-economic process and get more convoluted with the indeterminate classifications of digital assets. The ongoing SEC/CFTC challenge over the classification of a particular digital asset arises from the pre-existing regulatory frameworks which use the Howey test for making a determination and the associated oversight governing each class.
The Howey test was established by the Supreme Court’s case SEC v. W.J. Howey Co. (1946). It is a commonly used tool to determine if an investment contract qualifies as an “investment contract” and thus falls under the definition of a security. It involves assessing whether an arrangement involves an investment of money in a common enterprise with an expectation of profits derived from the efforts of others.
From a commodity standpoint, Ether (ETH) serves as the native cryptocurrency of the Ethereum network and is widely used as a medium of exchange within the broader platform ecosystem. It functions as a digital currency and is “minted” and “burned” (issued and spent) around smart contracts powering stablecoins and decentralized applications (DApps) built on the Ethereum blockchain. In this sense, Ether can be seen as a commodity similar to other crypto assets like Bitcoin or Litecoin, which can be used as a digital medium of exchange.
On the other hand, the Ethereum Foundation, the organization behind the development and maintenance of Ethereum, exercises control and governance over the platform, making decisions that impact its direction and functionality. For example, in 2016, the Foundation made a controversial decision to reverse a theft through a hard fork, which led to a split between Ethereum (ETH) and Ethereum Classic (ETC) the version that preserved the theft. Further, in switching its proof-of-work validation to proof-of-stake in 2022, Ethereum node validators will now consist of entities that buy into the platform with 32 ETH (current value close to $60,000). This type of control and decision-making authority concentrated in the hands of the few resembles characteristics commonly associated with securities.
So, why the big fuss?
The current regulatory framework limits the CFTC’s authority to anti-fraud and anti-manipulation on stablecoins and digital commodities in the spot market, which is insufficient to protect consumers because most intermediaries like brokers and exchanges are unaccounted for. The SEC has jurisdiction over the spot market for digital assets that may be regarded as a security. But how is a regulatory agency supposed to adjudicate between trades without setting clear criteria? Keep in mind that Ethereum is one of potentially thousands of cryptocurrencies that could fit the bill. The race is now on as institutional investors like BlackRock are starting to press for a Bitcoin Exchange-traded fund (ETF).
The lack of clear regulatory boundaries, standards, and consumer protections creates uncertainty for digital asset issuers, intermediaries, and market participants. This can lead to capital flowing to jurisdictions with more favorable regulatory environments. The classification debate around tokens further adds to the regulatory uncertainty. Tokens can have different characteristics, such as utility tokens, payment tokens, or security tokens. Establishing clear guidelines and definitions for token types is crucial for regulatory clarity and proper oversight.
Can the SEC and CFTC cooperate?
On May 10th, a joint subcommittee on Financial Services & Agriculture held a hearing titled The Future of Digital Assets: Measuring the regulatory gaps in the digital asset markets. The session further highlighted the difference in opinion and conflicting positions on which digital assets classify as commodities and which ones classify as securities.
The ex-chairman of the Commodity Futures Trading Commission, Timothy Massad, thinks the most effective way to cope with indeterminate asset classes would be for Congress to direct the SEC and the CFTC to jointly develop and enforce rules via a self-regulatory organization (SRO). The proposed SRO would be overseen by the joint authority of the SEC and the CFTC which, in theory, would ensure that the ensuing regulatory framework aligns with the mandates of both agencies. This solution aims to provide clarity for crypto operators and investor protection for users without requiring a complete overhaul of existing securities laws or forcing rigid classifications that may become obsolete before the market determines what to really do with crypto.
An SRO, as proposed, would be similar to organizations like the Financial Industry Regulatory Authority (FINRA) and the National Futures Association (NFA) in enforcing rules and standards on their members, but it would be specific to digital assets.
Massad’s proposal is worth considering. First, it brings the digital asset ecosystem within the appropriate regulatory purview, setting principles and enforcing standards that consumers take for granted in traditional finance. It defers the digital asset classification problem by allowing the market to play its course and letting regulatory categories emerge organically. In the meantime, the SRO would immediately curb wash trades, also known as ‘pump and dump’ schemes, including blatant conflicts of interests and co-mingling of funds as we saw with FTX. Second, it provides clear rules and business expectations for the key intermediaries involved in the crypto value chain, that is, broker-dealers, exchanges, and custodians like Coinbase, Kraken, Binance, and others. Third, by allowing asset class definitions to emerge ad hoc in the market, the SRO could allow the United States to remain competitive and flexible in the global digital asset market compared to Europe, attracting innovative talent and capital with it.
That said, the SRO might not address the broader regulatory challenges posed by stablecoins and other tokens. This could result in gaps down the line. However, Massad never claimed it was the end-all and be-all. Since no digital broker or exchange can exist without trading or holding BTC and ETH, this solution could be as Massad put it, “an incremental step in the right direction” that does not undermine “decades of securities law and jurisprudence.”
Massad’s proposal alleviates the burden on the public by having the industry bear operating costs, but also raises questions. Who would be staffing the SRO commission of industry experts and how to avoid industry capture and conflicts of interest? Collusion between regulators and former brokers, lawyers, and Wall Street CEOs is a common problem in finance. The viability of this solution, if implemented, would come down to its bylaws and oversight arrangements.
In the meantime, the onus is on those who disagree to come up with a better solution.
- The top 5 digital assets by market capitalization consist of Bitcoin, Ethereum, and stablecoins, which are valued at $959 billion at the time of writing. For comparison, the next 5 on the list are worth 5% of the first five.
- The European Council adopted the regulations on Markets in Crypto-Assets (MiCA) in May 2023 based on three broad asset class definitions, e-money tokens, asset-referenced tokens, and utility tokens.