Demystifying Digital Assets: CFTC’s Taxonomy Offers Clear Guidance

The proposed CFTC definition of Digital Assets avoids tying it to a technology or database like blockchain. The word `blockchain` is only found in one footnote with a reference to a JP Morgan insights paper[1]. The acronym DLT is also only found in the Appendix.

The suggested approach uses language that helps build bridges between this new world and the traditional world. The CFTC refers to Platform crypto-assets (what we call cryptocurrencies) and makes several great distinctions that provide clarity. In a world that is totally sold on GenAI and its potential, the term Digital Twins is welcome. Classifying certain Digital Assets as Digital Twins versus others as Digital Natives helps in understanding the difference between Bitcoin (BTC) and Tokenized Gold (XAUT[2]) for example, and $FOBXX (Franklin Templeton OnChain U.S. Government Money Fund) and a Security Token like INX.

The INX token was the first ever SEC-registered security token issued by INX Limited[3]. Upon launch in 2021, it raised $84 million. The INX Security token is a Digital asset with hybrid Security and Utility characteristics. Token holders receive an annual pro-rata 40% distribution of INX’s cumulative adjusted net operating cash flows and discounts on trading fees on the INX.One STO trading platform.

The CFTC classification and taxonomy makes clear that all alternative Digital assets are Digital Twins. Privately issued stablecoins are classified as money-like Digital assets, not money Digital Assets. An issuer that holds higher-risk backing assets in their collateral reserve or no backing assets is Not classified as a Money-like Digital Asset (a Stablecoin). Therefore, algorithmic stablecoins like Magic Internet Money (MIM)[4] or FRAX, the first stablecoin with part of its supply collateralized and part managed algorithmically, won’t qualify as stablecoins according to the proposed CFTC classification.

The CFTC defines a digital asset as “a controllable electronic record, where one or more parties can exclusively exercise control through transfer of this record and where the controllable electronic record itself is uniquely identifiable.”

It excludes controllable electronic records that exist in and function solely as part of a financial institution’s books and records.

Control in this context refers to the actual control to transfer Bitcoin for example (the digital asset ownership) which doesn’t exist in traditional electronic records of an asset. For example, the electronic records of my company at the commercial registry, or my car at the Motor Vehicle Registry are not such controllable electronic records.

Digital Assets may serve a variety of economic functions such as a store of value, medium of exchange or payment, a means for investment or trading, or a utility to access other goods, governance, or other services.

The features that matter in the CTFC proposed classifications are:

1. Issuer: Digital Assets can be issued by an entity or can be bearer (like Bitcoin).

2. Mechanism underpinning Digital Asset value: Digital Assets can be pegged (like Stablecoins) or unpegged like (Ether)

3. Rights conferral: legally enforceable claim or rights on the issuer (e.g. voting rights or cash flow rights of the underlying tokenized asset)

4. Fungibility: Fungible (e.g. Ether) or non-fungible (e.g. two USD-pegged stablecoins from different issuers)

5. Redeemability: Redeemable for the underlying or the notional amount or non-redeemable for any reference asset

6. Nature of Electronic Record: Digital Twin (from another system of record and reconciled — e.g. tokenized real estate) or Digital Native (Bitcoin)

The CFTC taxonomy categorizes digital assets into seven broad groups:

1. Money and Money-Like Digital Assets

o There are 4 subcategories here

o CBDCs (retail and wholesale)

o Bank deposits (Tokenized Deposits and Deposit Tokens are two different variations)

o “Reserve-Backed” Digital Currencies: a privately issued (e.g., by a financial market infrastructure provider digital token where the value of the issued token is backed by central bank reserves.- Synthetic CBDCs

Stablecoins are not new money and are categorized as Money-like Digital Assets. The importance of their non-fungibility has not been emphasized enough.

1. Financial Digital Assets (e.g., tokenized securities, derivatives)

Tokenized Security and Security Token, are different. The first is a Digital Twin and the second is a Digital Native.

The same difference holds between a Tokenized Derivative and a Derivative Token.

1. Alternative Digital Assets (e.g., tokenized real estate, commodities)

These are all Digital Twins — tokenized commodities, real estate, carbon credits, art etc.

1. Cryptoassets

The CFTC emphasizes the aspect of the platform created by the network infrastructure. This again is an elegant way to avoid linking Digital Assets to blockchains or any current database structure. The definition covers the built-in aspect of the blockchains on which Digital Assets are issued and suggests three types of utilities for these Digital Native tokens that are non-redeemable. The latter (non-redeemable) not to be confused that they can't be exchanged for another asset. It means ownership of these Digital Native tokens can't be relinquished for another asset like in the case of preferred shares or a fixed-income security.

1. Platform Cryptoassets: non-redeemable Digital Native tokens, with no rights conferred against the issuer (if one exists), that may be exchangeable for a specified value that is hard-coded into any underlying platform and must serve one or both of the following functions:

a. Cryptographic economic incentive to maintain and secure to network or application infrastructure including preservation of processing throughput (e.g., through payment of “gas fees” or staking); or

b. universal medium of exchange of the underlying network infrastructure.

Examples of Platform Cryptoassets include bitcoin or ether tokens

CTFC recognizes and distinguishes meme coins as separate.

2. Other Cryptoassets: non-redeemable Digital Native tokens, with no rights conferred against the issuer (if one exists), that are used as a speculative investment.

Examples of Other Cryptoassets include “meme-coins” such as shiba inu coin

1. Functional Digital Assets: These tokens cant be exchanged for other utility like governance or voting rights.
2. Settlement Tokens: not considered digital assets because they exist temporarily for record-keeping purposes.
3. Other Digital Assets (for future innovations)

Conclusion

The CFTC’s Global Markets Advisory Committee has taken a major step forward in providing much-needed clarity and consistency around digital assets. The proposed taxonomy offers a comprehensive framework for classifying different types of digital assets based on their characteristics and functions.

By building upon the work of global standard setters and engaging a wide range of stakeholders, this taxonomy aims to promote innovation, identify risks, and enable effective regulatory oversight of the rapidly evolving digital asset ecosystem.

As the digital asset industry continues to grow and mature, having a common language and classification system is crucial for regulators, market participants, and innovators.

The CFTC’s taxonomy underscores its adaptability to future developments in the digital asset space, reflecting a commitment to provide clearer upfront guidance that goes beyond the SEC’s piecemeal approach of analyzing whether each digital asset qualifies as a security under the Howey test on a case-by-case basis.

The CFTC’s proposed digital asset taxonomy has several similarities to the EU’s MiCA regulation. They are both comprehensive classification systems for the different types of digital assets based on their characteristics and functions. They both categorize certain crypto-assets like Bitcoin and Ether as “platform” or “crypto-asset” tokens. They both have separate categories for asset-backed tokens/stablecoins and tokenized traditional financial instruments like securities. They recognize the need for regulatory clarity and consistent terminology around digital assets.

On the other hand, there are differences as one would expect.

- The CFTC taxonomy focuses more on the features like issuance, rights conferred, fungibility, etc. while MiCA emphasizes what the crypto-asset represents (e.g. e-money, asset reference).

- MiCA has more granular sub-categories like e-money tokens, asset-referenced tokens, etc. while the CFTC uses broader buckets.

- The CFTC emphasizes the “digital native” vs “digital twin” distinction based on whether the asset originates on another system of record.

[1] 33 “Blockchain Brings collateral mobility to traditional assets”, JP Morgan Insights, 2022, https://www.jpmorgan.com/solutions/treasury-payments/insights/blockchain-onyx-asset-

Tokenization

[2] XAUT is Tether Gold token which is currently the largest Gold token by market cap ($535 million).

[3] INX Limited is a Gibraltar-based company

[4] Abracadabra.money is an Omnichain DeFi lending platform that works its magic by utilizing interest-bearing tokens as collateral to mint Magic Internet Money, a USD-denominated stablecoin.

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