The Senate Market Structure Approach Is the Best Path Forward

The most important characteristic of a market structure law is clarity.

We’ve written and spoken about the need for clarity in crypto regulations for years, and it’s been heartening to see first the House and now the Senate take up the cause of drafting and passing comprehensive crypto legislation.

But the details of market structure legislation matter. As we noted in our Principles on Market Structure Legislation, not all legislation is created equal. Market structure legislation must adequately protect DeFi, establish a clear test for which assets are securities, and recognize that “crypto assets are native digital assets imbued with property rights.” These principles underscore our belief that most crypto assets are generally distinct from securities because they have different attributes and key characteristics, including that they don’t derive their value from legal rights.

With that in mind, we have co-signed two comment letters in response to the Senate Banking Committee’s recent Discussion Draft on market structure legislation.

The first, drafted by the DeFi Education Fund, stresses the importance of protecting DeFi. As Dan said in his Senate testimony in July, it is essential that crypto market structure regulation not crush the decentralized trading protocols that make up an increasing share of crypto volume and constitute one of the foundational contributions of the industry. The letter by the DeFi Education Fund drills down on these points, arguing that there is a “fundamental distinction” between centralized intermediaries and software developers creating permissionless software. Additionally, the letter argues that blockchain technology should be treated as purely neutral infrastructure like the internet itself and not shoehorned into regulatory or compliance obligations that are ill-suited to it. The free and permissionless nature of the internet is core to its operation and to its design; we must provide the same protection and sanctity to permissionless blockchains.

The second letter focuses on four primary topics: token classification, investor protection, supporting innovation, and federal preemption of state securities laws. While all these topics are important, the letter’s focus is the first.

Notably, the approach to token classification in the Senate discussion draft is different from the approach taken by the CLARITY Act passed by the House. CLARITY is built around a “mature blockchain” test for determining when crypto assets fully move beyond the securities laws. The Senate discussion draft instead focuses on the idea of ancillary assets, which distinguishes the typical crypto asset from securities due to its innate nature. While there is no perfect way to provide regulatory clarity for crypto, we argue in our letter that the ancillary asset concept is the most practical.

As we note in our submission, “The ancillary asset concept is elegant in its simplicity: it defines an ancillary asset as an intangible asset sold in connection with an investment contract and clarifies (i) the ancillary asset itself is not a security, and (ii) secondary transactions in an ancillary asset are not securities transactions. Excluded from the definition are assets sold in connection with an investment contract that provides the owner of the asset with certain financial rights.” This is the basis of a standard in market structure legislation that is easily understandable to entrepreneurs, readily operationalized by policymakers, and clear to ordinary investors and users.

Our reasoning rests on two points: first, that the Howey test is a flawed tool for determining crypto jurisdiction; and second, that crypto assets lack the legal rights that define securities.

The Howey test, which was the linchpin of the Gensler SEC’s approach to crypto regulation, was universally unpopular among the investors it was meant to protect. One reason is that the Howey test is notoriously difficult to apply, and to predict. Howey was not created by Congress, but instead emerged as a judicial test, long-standing as a legal no-man’s-land. Only recently, with the rise of crypto, have we seen efforts to retrofit Howey into a jurisdictional framework for regulating an entire industry. The result has been confusion, with even judges calling the case-by-case application maddening.

Additionally, the Howey test, and the way it was enforced, created perverse incentives in the crypto industry that undermined the goals of investor protection. The test hinges critically on whether an issuer puts in any post-sale “efforts” to make a network valuable. When combined with the catastrophically punitive consequences of a securities classification for a token, and the difficulty of predicting how Howey would be applied, this had a predictable consequence: projects that launched a token for a network were discouraged from putting in further effort into the network.

The ancillary assets approach taken by the Senate bill takes advantage, in part, of a clearer and more predictable distinction: whether the asset comes with legal rights.1 Most securities – stocks, bonds, options, notes – derive their value from legal or contractual obligations, whereas crypto assets derive their value from code, and from the role they play in their protocols.

Some have raised concerns that this could undermine the traditional securities markets. But the notion that securities issuers could choose to simply remove all legal obligations from their instruments is farfetched. Imagine a bond issuer asking its investors to forego the clauses that require the issuer to repay its debt. Then imagine them explaining their rationale—that they are doing so in order to deprive the investor of their rights under the securities laws.

Without legal rights, stocks, bonds and similar instruments would be worthless, and no traditional securities investor would accept that tradeoff. Crypto assets, by contrast, can and do have value independent of such rights.

We believe the ancillary asset concept is preferable to the corresponding provisions of the CLARITY Act. While the CLARITY Act’s control-based test is a significant improvement on Howey’s efforts-based test, it introduces significant complexities of its own, and could perversely incentivize builders to limit the functionality of their protocols in order to check a regulatory box, in ways that do not serve the actual interests of investor protection.

Enacting crypto legislation is no small task, and we appreciate the efforts of many in Congress to craft market structure laws that balance the often competing needs of industry participants, stakeholders, and critics. We’re grateful for the opportunity to offer input to help improve this legislation. As Congress moves forward, we urge it to be guided by the principle that legislation should support the safe, sustainable growth of the industry, protect users and investors, serve the national interest, and remain workable for both companies and regulators. A law that demands millions of dollars and a team of elite lawyers to navigate would be a counterproductive outcome.

The full submission is available here.