Regulating crypto without exempting traditional finance is challenging, as shown in House Bill.

A draft bill has been proposed by House Financial Services Committee Chair Patrick McHenry (R-NC) and Agriculture Committee Chair Glenn “GT” Thompson (R-PA) on crypto legislation. The bill aims to exempt tokens from securities laws while keeping traditional securities issuers regulated. However, the bill only creates new regulatory uncertainty. Many in the crypto industry have supported the discussion draft, including former Commodities and Futures Trading Commission (CFTC) chair and current crypto adviser Christopher Giancarlo, who called it a “landmark bill,” and Coinbase’s Chief Legal Officer Paul Grewal, who said it was ” a strong step forward ” to legislating on financial regulators’ jurisdiction over crypto.

The debate over crypto assets is about whether a given token is an investment contract, and therefore a security, under the securities laws. The basis for the Securities and Exchange Commission’s (SEC) lawsuits against Coinbase and Binance is the so-called Howey Test, which became a standard way of determining what assets are securities after the 1946 Supreme Court case SEC v. Howey Co.

McHenry and Thompson attempt to sidestep the Howey Test entirely. Their bill would create a new asset class called “digital assets.” Digital assets can come in many forms, but two particularly important ones are “digital commodities” and “restricted digital assets.”

Restricted digital assets are still securities under the Howey Test but would be exempted from significant parts of the securities laws. If a token issuance meets six qualifications defined under the bill, a more lenient set of disclosure requirements would apply. Once they mature into digital commodities, they would be exempted from the securities laws entirely.

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However, one of those six qualifications is that the sale of the digital asset cannot “involve the offer or sale of equity securities, debt securities, or debt securities convertible or exchangeable to equity interests.” This would prevent cryptocurrencies from representing an ownership stake in a venture or being used like bonds to raise capital.

The McHenry-Thompson bill does not define the terms. While equities are generally thought of as simply stock in corporations, the term “equity security” is defined in the Securities Exchange Act of 1934 as “any stock or similar security … or any other security which the Commission shall deem to be of similar nature” (emphasis added).

The bill would not affect the definition of “investment contract” and would have the SEC decide which of those tokens are equity or debt securities. This may result in the SEC deeming most, if not all, crypto tokens that meet the Howey Test to be equities subject to traditional securities law disclosures.

Other options to remove SEC discretion while preventing regulatory arbitrage would similarly fail. A bill that carves crypto out of the Howey Test would turn the securities laws from being technologically neutral to one that benefits blockchains over everything else.

There are several issues with the bill, one of which is that it would give the CFTC new authority without providing additional funding. Additionally, it seems that DeFi exchanges would be exempt from certain investor protection measures that CeFi exchanges must follow. The CFTC would also be able to exempt large portions of digital commodity markets from customer protection provisions, making regulation of exchanges and brokers optional.

The main concern, however, is regulatory arbitrage. Although Chairs McHenry and Thompson attempted to create a bill that would allow crypto assets to avoid securities laws, their legislation, like others before it, demonstrates how difficult this is without also providing traditional securities with a new way to opt-out of those laws.

Edited by Jeanhee Kim and Daniel Kuhn.