Source: TradingView, CNBC, Bloomberg, Messari
***This week's edition is written by David Nage, Portfolio Manager at Arca***
A Regulatory Victory That Might Destroy What It's Trying to Save
Last week brought what should have been unqualified good news for our industry. The House passed the CLARITY Act, the GENIUS stablecoin bill advanced, and the Senate Banking Committee released its own comprehensive discussion draft for digital assets market structure. For the first time since we started Arca in 2018, we have multiple pathways toward real regulatory clarity.
But buried in the Senate's 35-page discussion draft is a definition so problematic that it could inadvertently destroy the entire crypto venture capital ecosystem. And barely anyone is talking about it.
While the industry celebrates the progress on staking clarity and stablecoin regulation—both genuinely positive developments—a three-word phrase in Section 4B(a) threatens to make every token issued through a venture-backed startup permanently unmarketable to the very investors funding crypto innovation.
The "Ancillary Asset" Time Bomb
The Senate Banking Committee's draft introduces the concept of "ancillary assets"—essentially tokens that can be treated as commodities rather than securities if they meet certain criteria. This sounds helpful, and in theory it is. The problem lies in how they've defined these assets.
Section 4B(a)(1)(A) defines an "ancillary asset" as a token "that is offered, sold, or otherwise distributed to a person in connection with the purchase and sale of a security through an arrangement that constitutes an investment contract."
Those three words—"in connection with"—would destroy the dominant fundraising structure that's emerged in crypto since the 2022 collapse of FTX and Celsius.
How Crypto Venture Capital Actually Works
To understand why this matters, you need to understand how crypto startups have raised money since the regulatory environment turned hostile. The wild west ICO days are long gone. Today's reality looks like this:
The Standard Post-2022 Structure:
- Year 0: VC invests in a SAFE (Simple Agreement for Future Equity) for company equity
- Year 0: VC also receives a warrant giving rights to future tokens when the company issues a token
- Year 2-3: Company launches operational network and tokens
- Year 3: VC exercises warrant to receive tokens that now have genuine utility
This structure solved multiple problems:
- Legal separation between equity investment (clearly a security) and utility tokens
- Temporal separation allows tokens to develop genuine use cases
- Economic separation where tokens derive value from network usage, not just company performance
The powerful idea behind this structure is that by the time tokens are distributed, the project has found its product market fit and tokens now represent genuine utility in the working network—like arcade credits or subway tokens—rather than speculative bets on a company's future success.
Why the Senate Definition Kills This Structure
Under the proposed definition, tokens distributed through these warrants could be forever tainted because they were distributed "in connection with" the original SAFE purchase. No matter how much genuine utility the tokens develop, no matter how decentralized the network becomes, they can never qualify as "ancillary assets" because of their distribution history.
This creates an existential problem for venture capital funds. Most VC funds cannot hold securities long-term due to:
- Limited Partnership Agreement restrictions limiting investments to venture capital
- Investment Company Act exemption requirements restricting passive securities holdings
- Tax qualification issues around carried interest and pass-through status
- Fiduciary duty constraints requiring adherence to fund mandates
If tokens from warrant exercises remain securities rather than commodities, VCs would be forced to immediately sell them or violate their fund restrictions. This doesn't just create regulatory uncertainty—it makes the entire asset class uninvestable for the primary source of early-stage crypto funding.
The Broader Regulatory Picture
This isn't to say the Senate draft is all bad. There are genuinely positive developments:
GENIUS Act stablecoin framework provides the regulatory clarity that enabled Circle's 1000% post-IPO surge and should accelerate institutional adoption of USD- denominated stablecoins.
Enhanced staking clarity finally resolves the regulatory uncertainty that has plagued everything from Coinbase's staking services to liquid staking protocols like Lido. Our analysis suggests this could drive significant revaluation in staking infrastructure tokens.
Choice between regulatory pathways could solve the forced decentralization problem we've written about extensively, where application tokens are destroyed by being forced to operate like Bitcoin rather than like businesses.
But none of these benefits matter if the "ancillary asset" definition accidentally diminishes the role of venture capital in crypto.
Real-World Impact on Innovation
As an example, let’s consider a typical Arca portfolio company: it probably raised $20M through SAFEs in 2023, has been building its product for two years, and is now preparing to launch its network in 2025. Under current law, there's regulatory uncertainty about its potential tokens. Under the Senate framework, there would be regulatory certainty—certainty that the company’s tokens remain securities forever, making them effectively uninvestable.
This isn't just a theoretical situation. We estimate that this rule could affect the majority of venture-backed crypto companies funded since 2022. These companies are building the next generation of DeFi protocols, infrastructure tools, and blockchain applications that will drive the industry forward.
The irony is stark: a bill designed to provide regulatory clarity for digital assets could eliminate the funding mechanism that creates those assets in the first place.
The Three-Word Fix
We believe that the solution is remarkably simple. The definition should focus on the intrinsic characteristics of tokens rather than their distribution history. Instead of requiring that ancillary assets be distributed "in connection with" securities, the definition should rely solely on the "disqualifying financial rights" test already included in Section 4B(a)(1)(B).
A token that provides genuine utility without giving holders debt, equity, dividend, or liquidation rights should qualify as an ancillary asset regardless of how it was initially distributed. This would preserve the venture capital structures that fund innovation while maintaining investor protection through the economic substance test.
This isn't about creating loopholes—it's about recognizing economic reality. A token that allows for the storage of files on a decentralized network or trade on a decentralized exchange has commodity-like utility, regardless of whether the token is received through a warrant, an airdrop, or a direct purchase.
Why This Matters Now
The Senate Banking Committee is actively soliciting feedback on its discussion draft, with responses due August 5th. This is a rare opportunity to fix a potentially catastrophic unintended consequence before it becomes law.
The crypto industry has learned to adapt to regulatory uncertainty, building compliance frameworks and working within existing securities laws when necessary. But adaptation has limits. It’s impossible to adapt when a core business model becomes illegal.
The Stakes
We're at a crucial inflection point for crypto regulation in the United States. Get it right, and we establish America as the global leader in digital assets innovation while protecting investors. Get it wrong, and we risk driving the next generation of blockchain companies to Singapore, Switzerland, and the UAE, putting the U.S. at a competitive disadvantage.
The Senate Banking Committee clearly understands the importance of getting this right—their 85-question RFI demonstrates serious engagement with the technical and economic complexities of digital assets. But good intentions aren't enough when three words in a definition can undermine the entire venture capital ecosystem.
This isn't about asking for special treatment for venture capital. It's about asking for definitions that reflect economic reality and don't accidentally destroy the funding mechanisms that create the very assets the legislation is trying to regulate.
The path forward is clear: fix the "ancillary asset" definition to focus on token characteristics rather than distribution history. The alternative—a regulatory framework that eliminates early-stage funding for crypto innovation—would be a tragedy for American technological leadership.
