Why FIT21 matters: Definition of decentralization and determining whether an asset is a digital commodity
If a digital asset is decentralized, the CFTC, not the SEC, will be in charge of its regulation.
- The newly approved FIT21 says the SEC doesn’t have control of decentralized digital assets.
- A five-prong decentralization test can reportedly be used to determine whether an asset is a digital commodity.
In an interesting turn of events, FIT 21, formally known as HR 4763, was just passed with the support of a third of Democrats and almost all Republicans. It outlines the boundaries of the SEC and CFTC on digital assets. In summary:
- CFTC — Regulates digital assets if the associated blockchain or digital ledger is both functional and decentralized.
- SEC — Regulates assets and securities if the blockchain is functional but not decentralized.
The newly passed bill provides definitions of “Decentralized Network,” “Decentralized Governance System” and “Decentralized Finance.” A five-prong test can reportedly be used to tell if a digital asset is decentralized and not subject to SEC regulations.
What is FIT21: 71 Democrats and 208 Republicans voted pro HR 4763
Decentralized Definitions
The bill clarifies the difference between a general decentralized network compared to its decentralized governance system. It also provides a clear definition of decentralized finance DeFi.
Decentralized Network
With respect to a blockchain system to which a digital asset relates, it can only be called a “decentralized network” if the following are met:
- In the past 12 months, no single person had the power to control, change, or restrict the blockchain system from any person who wasn’t an issuer, related person, or affiliated person. This includes participating in decentralized governance, running nodes, or creating software for the system.
- In the past 12 months, no issuer or affiliated person owned 20% or more of the total units or outstanding voting power of the digital asset.
- In the past 3 months, the issuer or its affiliates haven’t changed the source code unless it was to fix problems, or the changes were agreed upon by the community.
- In the past 3 months, the issuer or affiliated/related hasn’t marketed to the public the digital asset as an investment.
- In the past 12 months, all units were end user distributions made through the blockchain system.
Decentralized Governance System
With respect to a blockchain system is any rules-based system permitting people to form consensus or agreement in the development, publication, management, provision, or administration of the blockchain system.
Persons in the decentralized system will be treated as separate UNLESS such persons are under common control.
Its exclusions are when a person or group of persons under common control can unilaterally alter rules of consensus, determine final outcome of decisions, and engage in an activity requiring registration with the CFTC.
Decentralized Finance
This refers to blockchain protocols that allow users to engage in financial transactions in a self-directed manner without a third party effectuating transactions or taking custody of digital assets during transactions.
5-Prong Decentralization Test
Jasper, Rocket Pool community advocate, and former pDAO treasurer, shared a five-prong decentralization test on X that would reportedly help determine whether an asset is a digital commodity.
Prong 1 — Power Rule
(i) — no person can change the code (in the past 12 months).
(ii) — no person can prohibit others from using the system (in the past 12 months).
This would mean it would require the protocols’ admins not to have the power to censor users.
Prong 2 — Ownership and Voting
(i) — no issuer or affiliated person can own 20% of the asset (in the past 12 months).
(ii) — no issuer or affiliated person can direct 20% of voting power (in the past 12 months).
(iii) — the digital asset did not include voting power.
This would automatically change the common practice of tokenomics, wherein some projects leave 20% to their employees, investors, foundations, and other affiliated people. With the new rule, projects that do so can no longer be categorized as “decentralized.”
Prong 3 — Code Changes
(i) — no code changes were made except for maintenance, bugs, and vulnerabilities (in the past 3 months).
(ii) — no code changes were made except those adopted through consensus or agreement of a decentralized governance system.
This would mean development teams would have to take a backseat to DAOs.
Prong 4 — No Marketing as an Investment
The asset shouldn’t have been marketed as an investment in the past 3 months.
Prong 5 — Inflation
Token issuance must be end-user distributions through the blockchain in the past 12 months.
Per Jasper, this meant an airdrop that was:
- broadly distributed
- relates to the chain’s nature
- based on another asset’s holdings
Due to Prong 5, inflation won’t go to DAOs. However, it can be used to incentivize mining, staking, or other similar activities. Jasper notes that the five prongs would classify many popular governance tokens as securities and that adhering to the prongs would result in less fraud.
FIT21 mentions “issuers,” “affiliated person,” and “related person,” among participating parties and restrictions. Although often grouped together, they do have distinctive differences.
Affiliated Person — Anyone with formal connections to the founding team or company.
Related Person
(i) — A founder, promoter, employee, consultant, or advisor.
(ii) — Anyone who served as an executive officer, director, board member, or other similar roles in the past 6 months.
(iii) — Any equity holder or other security holder of a digital asset issuer.
(iv) — Any person receiving a unit of digital asset through exempt offering or distribution that wasn’t an end-user distribution.
