What's "Decentralized Governance System" Under the FIT Act of 2023?

The Financial Innovation and Technology for the 21st Century Act, often referred to as the FIT Act of 2023, has introduced several important definitions that directly impact the world of digital assets. Among these is the term “Decentralized Governance System.”

In this article, we will delve into what this term means under the FIT Act and its implications for blockchain systems.

Decentralized Governance System: A Closer Look

The FIT Act outlines three main components of a decentralized governance system:

1. Rules-Based System: This component stipulates that a decentralized governance system must operate based on a set of predefined rules. This is a critical aspect as it ensures that the system operates in a predictable and transparent manner, which is vital for user trust and system stability.
2. Consensus or Agreement: This component emphasizes the need for participants in the system to reach consensus or agreement on the operation of the blockchain system. This reflects the fundamental nature of blockchain systems, which operate based on consensus mechanisms that validate transactions and maintain the integrity of the blockchain.
3. Absence of Centralized Control: The system must not be under the control of a single entity or group of entities. This aspect is crucial to maintaining the decentralized nature of the system and ensuring that no single participant can unduly influence the operation of the system or the value of the associated digital assets.

Under the FIT Act, a decentralized governance system is defined as any rules-based system that permits users of a blockchain system or the related digital assets to form consensus or reach an agreement regarding the development, management, provision, publication, or administration of such a blockchain system.

This definition recognizes the unique aspect of blockchain technology, where users are involved in the decision-making processes in a decentralized manner, which is often facilitated through consensus mechanisms inherent in the system.

However, the Act makes it clear that individuals acting through a decentralized governance system are treated as separate entities unless they are under common control. This distinction is important as it helps avoid conflating the actions of individual participants with those of the entire network.

Exclusions from the Definition of a Decentralized Governance System

The FIT Act carefully outlines certain exclusions from the definition of a decentralized governance system. These conditions are put in place to ensure that the term isn't misused and that the integrity of truly decentralized systems is maintained.

1) Unilateral Control

The FIT Act makes it clear that a system in which a person or group of persons under common control can unilaterally alter the rules of consensus or agreement for the blockchain system or determine the final outcome of decisions related to its operation does not fall under the definition of a decentralized governance system.

This exclusion aims to prevent a single entity or group from exerting disproportionate control, which would undermine the decentralized nature of the system.

2) Activities Requiring Registration

A system also falls outside the definition of a decentralized governance system if a person or group of persons is directly engaged in an activity that requires registration with the Commission or the Commodity Futures Trading Commission (CFTC), unless they are developing, managing, or administering a blockchain system or conducting an activity for which the organization is exempt from such registration.

This provision ensures that organizations cannot evade regulatory responsibilities by operating under the guise of a decentralized system.

3) Evasion of Regulatory Requirements

The FIT Act also excludes systems where a person or group of persons is seeking to knowingly evade the requirements imposed on a digital asset issuer, a related person, an affiliated person, or any other person registered (or required to be registered) under the Act, the FIT Act, or the Commodity Exchange Act.

This exclusion is designed to prevent the misuse of the label of a decentralized governance system to avoid regulatory compliance.

These exclusions are critical in maintaining the integrity of the definition of a decentralized governance system. They ensure that the term is not misused to bypass regulatory requirements or to exert unilateral control over a blockchain system. This clarity in definition serves to preserve the unique characteristics of truly decentralized systems, protect consumers, and uphold regulatory standards.

Importance of the Decentralized Governance System Concept in the Context of the FIT Act

The evolving nature of blockchain technology and digital assets has necessitated the creation of new regulatory frameworks that can adequately capture these unique systems. The concept of a decentralized governance system, as defined in the FIT Act, plays a crucial role in this regulatory landscape.

Blockchain systems that are truly decentralized, as per the FIT Act's definition, fundamentally alter the power dynamics found in traditional financial systems. They distribute control across a wide network of participants rather than concentrating it in a single institution or group of institutions. This characteristic has profound implications for how these systems are regulated.

1) Regulatory Classification

One of the most critical aspects of the decentralized governance system definition is its impact on the regulatory classification of associated digital assets. If a digital asset is part of a blockchain system that meets the criteria for a decentralized governance system, it is generally not considered a security.

Securities, traditionally understood as investments, are subject to a significantly more stringent regulatory regime, including registration requirements, reporting obligations, and investor protections.

The exclusion of truly decentralized digital assets from this classification can reduce regulatory burdens and foster innovation.

2) Investor Protection

The definition of a decentralized governance system also has essential implications for investor protection.

By clearly delineating what constitutes a decentralized system, the FIT Act can help prevent deceptive practices where entities might claim their systems are decentralized to avoid regulation, when in fact they maintain significant control.

By specifying the conditions for decentralization, the Act can prevent such misrepresentations and protect investors.

3) Promoting Decentralization

The definition of a decentralized governance system can promote the development of more decentralized blockchain systems.

By providing a clear regulatory advantage to systems that meet the criteria for decentralization, the Act can incentivize the development of truly decentralized systems.

This can foster innovation and the development of new technologies that leverage the unique benefits of decentralization.

4) Clarity and Legal Certainty

Finally, the definition of a decentralized governance system provides much-needed clarity and legal certainty in the rapidly evolving blockchain industry. It offers a clear criteria to judge whether a system is decentralized and how it will be regulated.

This clarity can be beneficial for blockchain developers, digital asset issuers, and investors alike.

In summary, the concept of a decentralized governance system is a cornerstone of the FIT Act's approach to regulating digital assets. It provides a clear framework for distinguishing between different types of blockchain systems, influencing how they are regulated, and protecting investors from potential misrepresentations.

Why Non-Decentralized Digital Assets May Be Considered Securities

In the context of the FIT Act, digital assets associated with a blockchain system that is not decentralized may be classified as securities due to the presence of certain characteristics typically associated with investments.

1) Control Over Price

A lack of decentralization often means that a single entity or group of entities has significant control over the blockchain system and, by extension, the digital asset. This control can include the ability to influence the price of the digital asset.

For instance, they may be able to alter the supply of the asset or make decisions that significantly impact its value. This ability to control price aligns with traditional characteristics of securities, where the value of the investment is significantly influenced by the efforts of a third party.

2) Expectation of Profit

Digital assets associated with non-decentralized systems often carry an expectation of profit, another hallmark of securities. This expectation is typically based on the efforts of the controlling entity or entities.

For example, if the entity in control undertakes development efforts that increase the utility of the digital asset, the value of the asset may rise, leading to profits for holders.

3) Investment of Capital

Just like with traditional securities, acquiring digital assets often involves the investment of capital. Users may purchase these assets with the expectation that their value will increase over time due to the efforts of the controlling entities.

4) Regulatory Oversight

When a digital asset is classified as a security, it falls under the regulatory purview of securities regulators, such as the Securities and Exchange Commission (SEC) in the United States. These regulators enforce rules and regulations designed to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.

Non-decentralized digital assets classified as securities would therefore be subject to these rules and regulations, including registration requirements, disclosure obligations, and anti-fraud and manipulation measures.

In summary, the classification of non-decentralized digital assets as securities stems from their alignment with traditional characteristics of investments, including an expectation of profit primarily from the efforts of others and the investment of capital.

This classification subjects these digital assets to a regulatory regime designed to protect investors and ensure the integrity of the markets in which they trade.

Conclusion

The FIT Act's definition of a decentralized governance system is a crucial step in the development of a comprehensive regulatory framework for digital assets. This definition not only distinguishes between truly decentralized systems and those that are not but also has significant implications for the regulatory status of associated digital assets.

While the definition provides a robust framework for understanding how decentralized governance systems function, it is still relatively new, and further clarifications might be forthcoming. As we move forward, it will be interesting to see how this definition is applied and interpreted in the rapidly evolving world of blockchain technology and digital assets.

Related: How The FIT Act Defines & Deals with "Decentralized Network"?