In the rapidly moving world of digital assets, specifically non-fungible tokens (NFTs), we begin to gain some clarity on their future. Creators and regulators alike have speculated about when and how NFTs will be regulated. A bill proposed in the U.S. Senate provides some insight into how the federal government may seek to regulate NFTs and other digital assets and vehicles.
The Responsible Financial Innovation Act
Guardrails are proposed to be placed around the growing industry of digital assets. The Responsible Financial Innovation Act, spearheaded by Senators Kristen Gillibrand and Cynthia Lummis, proposes that the vast majority of digital assets (including NFTs) be classified as commodities (such as wheat, oil or steel) rather than as securities. Oversight responsibility would be on the shoulders of the Commodity Futures Trading Commission (CFTC), not the Securities and Exchange Commission (SEC).
A few months back the SEC stated, “NFTs can be deemed securities if they pass the so-called ‘Howey Test,’ a regulatory standard used to determine if the transaction has an investment contract.” Even with the stage set for NFTs to be treated as commodities, the SEC may still view fractional NFTs (f-NFTs) within its purview based on the view that they can be used to raise money in the manner of a traditional security (packaging f-NFTs allows an issuer to sell pieces of the NFT).
The CFTC was created to regulate commodity futures and option markets. Its mission is to protect market participants and the public from fraud and abuse, as well as systemic risk associated with derivatives subject to the Commodities Exchange Act (CEA). The allocation of responsibility to the CTFC comes as a surprise to some and may alter the way in which businesses breaking into the emerging space of digital assets plan to conduct business.
The bill is a first proposal to structure the markets for digital assets with long-awaited legal definitions. The proposal creates a complete regulatory framework for digital assets, encouraging responsible financial innovation, flexibility, transparency, and robust consumer protections while integrating digital assets into existing law.
The bill defines digital assets as a “natively electronic asset that confers economic or proprietary access rights or powers and includes virtual currency and payment stablecoins.” It explicitly states cryptocurrencies and other digital coins will not be treated like traditional securities under SEC scrutiny unless they entitle the holder to the privileges enjoyed by corporate investors such as dividends, liquidation rights, or a financial interest in the issuer.
NFTs as Commodities
A commodity includes all goods and articles, services, rights, and interests which are the subject of a contract for future delivery or provision. Generally, the key terms of a futures contract include an agreement (1) to purchase or sell a commodity for delivery in the future, (2) at a price that is determined at the time of the agreement, (3) with fulfillment effected by physical delivery, (4) which is liquidated before the delivery date and, (5) which must be traded or exchanged by persons and firms registered with the CFTC.
This raises the question of what “physical delivery” means in the context of an NFT; and may create different implications whether there is an additional asset connected to the NFT or if it is in reference to the NFT itself. NFTs could ultimately be a forward, future, or swap even if the represented asset is not. A forward contract enables parties to buy or sell an asset at a specified price on a future date and is typically used for hedging. A futures contract is similar, where it is an agreement to buy or sell a certain commodity at a pre-determined price in the future and positions are settled daily. Lastly, a swap contract is where parties agree to exchanging variable performance for a fixed market rate.
If an NFT is considered a commodity, the CEA could apply in one of two ways. First, the CEA’s general prohibitions on deceptive and manipulative trading may apply to NFT dealings effected as fully funded, unleveraged transactions (where there is no debt involved). This creates greater protections for NFT transactions because of the duties of inquiry, diligence, and disclosure imposed on sellers. If the NFT is offered on a margined or leveraged basis (where the seller can trade positions larger than the amount in their trading account), additional requirements would apply, such as the requirement to trade the NFT solely on a registered derivatives exchange unless the transaction meets the exception that “physical delivery” is made within 28 days of the date of the transaction.
The digital asset industry is continually evolving, and the stated goal of Congress is to create legislation that promotes innovation while simultaneously protecting consumers against fraud, misinformation, and resulting market volatility. The CFTC (which will regulate NFTs) oversees the purchase and sale of raw commodities. The bill requires all digital asset issuers to (1) maintain high-quality liquid assets valued at 100% of the face value of all outstanding payment, (2) publicly disclose relevant information about the assets backing the stablecoin and their value, and (3) have the financial backing to redeem all outstanding stablecoin payments at par.
The ramifications of the bill are extensive. Its size and complexity could necessitate lawmakers to pass its components in pieces over time. Regardless, the bill shines some much needed clarity on how Congress has been discussing the regulation of commodities and enables businesses and issuers interested in offering to prepare for coming regulation and oversight.
This alert does not purport to be a substitute for advice of counsel on specific matters.
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