SEC Seeks Additional Comment on Whether DeFi Systems Must Register as "Exchanges"
The Situation: The U.S. Securities and Exchange Commission ("SEC" or "Commission") has reopened the comment period for its January 2022 proposal to amend Exchange Act Rule 3b-16 to broadly expand the definition of an "exchange," which would require numerous persons and entities to register as exchanges or register as broker-dealers and comply with Regulation ATS. The move was in response to commenters who raised concerns that the proposed definition would include trading systems for crypto asset securities and trading systems that use distributed ledger or blockchain technology ("DLT"), including decentralized finance ("DeFi") systems.
The Issue: In its reopening release, the Commission addresses not only the potential application of the proposed amendments to Rule 3b-16 to trading systems for crypto asset securities but also the various persons or groups of persons that could constitute an "exchange" even without a centralized body managing the blockchain. The Commission also made clear that it expects the new rules to increase costs for DeFi, possibly forcing them to leave the United States or to cease to operate altogether.
Looking Ahead: The Proposal invites new comments on a number of questions about the proposed amendments' application to DLT systems and DeFi, and supplements the SEC's previous cost–benefit analysis to include systems trading crypto securities. The reopening of the comment period and the SEC's attempt to bolster its economic rationale for the expansion of the Rule to DLT systems is likely to engender additional strong dissent from the fintech community, which already believes the SEC has overreached its mandate in the area.
The SEC's Proposal, Supplemental Information, and Reopening the Comment Period
On January 26, 2022, the SEC proposed to amend Exchange Act Rule 3b-16 to, among other things, broadly expand the meaning of an "exchange" to include, among other things, DeFi (the "Proposed Rules"). After two 30-day comment periods in spring 2022, the SEC received roughly 250 comments on the Proposed Rules. On April 14, 2023, the SEC published a 166-page release (the "Release") reopening the comment period for its proposal, providing supplemental information regarding the potential impact of the proposed rule amendments on DLT, and requesting further information and comment on the Proposed Rules. The new comment period will run for 30 days after publication of the reopening release in the Federal Register, or until June 13, 2023, whichever is later.
In the Release, the Commission essentially assumes that DeFi systems, as a rule, trade in securities. In the SEC's view, then, under Rule 3b-16, any "organization, association, or group of persons, whether incorporated or unincorporated" that "constitutes, maintains, or provides" the "functions commonly performed by a stock exchange" for crypto assets would be an exchange. This view is consistent with the numerous public statements by SEC commissioners and other senior SEC staff that almost all crypto assets are, in their view, securities. It is also in line with the SEC's April 17, 2023, announcement of a litigated enforcement action against Bittrex, Inc. for, among other things, operating an unregistered crypto asset exchange.
As argued by the SEC, the fact that DeFi lacks—by definition—a centralized organizing body does not prevent persons involved in DeFi from being considered as part of a "group of persons" that otherwise constitutes an exchange. Rather than providing an actual definition of the type of group that would constitute an exchange, the Commission explained that whether a person would be part of a "group" that is an exchange would depend on the totality of the circumstances and the activities of the person. Factors such as whether the persons acted in concert or shared control over the functions commonly performed by a stock exchange are identified as generally important.
For example, an operative "group" for exchange definitional purposes likely would not include a software developer who independently published code later adopted by unrelated persons to trade securities as in a stock exchange; however, it could include those who act in agreement to facilitate the marketplace, such as service providers or vendors such as digital wallet providers, blockchain miners, and validators. One issue arising from this conclusion is that these types of service providers would have little, if any, supervisory authority over or responsibility for activity taking place on the DLT trading systems, making compliance with exchange governance obligations difficult for them at best.
Likely in an attempt to bolster the economic analysis underpinning its proposal in anticipation of a legal challenge if the Proposed Rules are adopted, the new Release includes an economic analysis considering the impact of the proposed rules on DLT trading systems that trade crypto asset securities. Notably, the Commission's new economic analysis appears to have simply applied its previous cost estimates relating to non-crypto firm compliance with the Proposed Rules to an estimated new 20 blockchain participants that it believes would be subject to the Proposed Rules.
In addition to both direct and indirect costs associated with broker-dealer registration and compliance with Regulation ATS (i.e., the available alternative to "exchange" registration), however, the Commission asserted that the nature of DLT further increases the price of compliance. In this regard, higher costs would accrue to systems that use smart contracts controlled by numerous token holders (via governance tokens), who could be required to form an organization and designate an agent in order to register as an exchange.
Thus, the SEC contemplated that compliance obligations might force token holders to sell their tokens to avoid taking on regulatory burdens (apparently not considering that selling merely transfers the potential expense to the buyer). It also posited that existing DLT trading systems using immutable smart contracts could nevertheless face cost and practical challenges with respect to bringing the system into compliance with the proposed rules, since miners and validators, for example, may be able to effect a change to a blockchain through a fork in the blockchain. This would mean that miners and validators could be included in the group that is the "exchange" with respect to a DeFi system. As an alternative, the Commission suggested that such systems "could be restructured to make less extensive use of these novel technologies."
The SEC further asserted that the amendments' benefits would be that similarly situated persons—here, existing registered exchanges, ATSs, and what the release calls "New Rule 3b-15(a) Systems"—will be situated similarly. Even though it recognized that the new rules would increase barriers to entry and reduce operational flexibility, thereby decreasing innovation and competition, the SEC claims that forcing these systems to operate "on a more equal basis," through requiring public disclosure on Form ATS-N, would advance the SEC's policy objectives related to "oversight, investor protection, and the fair and orderly market principles applicable to registered exchanges and ATSs."
Admitting that it "has a greater degree of uncertainty in its analysis of the costs that the Proposed Rules would impose on market participants for crypto asset securities than it did in its discussion of costs for non-crypto asset securities," and that it lacks "sufficient data on crypto asset securities," the Commission preliminarily concluded that "actual costs may be higher than [its prior] estimates and discussions express, due to the type of technology and operations utilized in trading crypto asset securities." To that end, the SEC solicited additional comment on the impact and cost of the new rules on DeFi, pairs trading (i.e., involving two assets that may or may not both be securities), automated market makers, decentralized autonomous organizations, bilateral voice trading, and the types of protocols used in trading crypto assets. The Commission also asked whether commenters agreed with its characterizations and sought examples as use cases.
The Dissent and Comment Period
As has been the case with many of the SEC's recent rule proposals and other orders touching on fintech-related regulation, the Commissioners split, 3–2, on whether the SEC should reopen the comment period. Representing the majority, Chair Gary Gensler argued that "the vast majority of crypto tokens are securities," and many crypto trading platforms are already exchanges under existing rules. He asserted that the proposal would promote resiliency, access, and fairness.
Representing the dissenting view, Commissioner Hester Peirce argued that, as a result of the application of the amended rules to DeFi, the Commission not only would encourage expatriation by raising U.S. operating costs, but moreover would be welcoming the extinction of new technology. She encouraged the SEC to nurture innovations in the market that do not fit squarely in the regulations' round holes, citing to a decades-old example when the SEC permitted new systems and ultimately developed a more tailored regulatory framework (i.e., Regulation ATS) considered successful today.
Commissioner Peirce further felt the Release lacked evidence of U.S. consumer benefits. She opined that the Release's confusing and unworkable standards raised vagueness concerns under the First Amendment and failed to define the key term "communication protocol system." She also emphasized that some organizations, such as Coinbase, that tried to register in good faith with the SEC, were rejected or rewarded with an enforcement action.
Potential for Challenge
Reopening the comment period will allow the SEC to gather more data that could support the amendments if enacted as proposed. The proposal is likely to face resistance from those who view the new rules as jurisdictional overreach by the SEC. The federal judiciary will almost certainly field a litany of legal challenges. The same day the SEC issued the Release, for instance, in a case challenging the constitutionality of agency administrative proceedings, the Supreme Court held that the statutory review scheme set out in the Securities Exchange Act "does not displace a district court's federal-question jurisdiction over claims challenging as unconstitutional the structure or existence of the SEC." See Axon Enter., Inc. v. FTC, 598 U.S. ___ (Apr. 14, 2023).
Given the Supreme Court's increasing proclivity toward agency restraint and deference to the clear mandates of Congress, courts may be hesitant to permit the Commission to stretch the statutory limits of its power too far beyond the bounds of the Exchange Act to envelop crypto trading systems without either a sufficient cost-benefit analysis or clear directive from Congress.
Four Key Takeaways
- The SEC reopened the comment period for its proposed amendments to Exchange Act Rule 3b-16, supplementing the proposed rules with further cost-benefit analysis and inviting further comment on the impact of the new rules on crypto, blockchain, and DeFi.
- The inclusion of "communications protocol systems" within the definition of "exchange" may bring platforms facilitating digital asset transactions within the regulatory ambit of the SEC. If enacted, the SEC's proposed amendments would remove the ability to act peer-to-peer or peer-to-protocol and would require registration as: (i) an exchange or (ii) a broker-dealer and an ATS. For instance, even miners, validators, or digital wallet providers may be considered part of the group of persons providing an exchange and thus required to register.
- The SEC's proposed amendments admittedly would significantly raise compliance costs for facilitating the exchange of digital assets, which could send such activity overseas or cause it to fail.
- Because this proposal is so broad, and dramatically expands the Exchange Act's definition of "exchange," the proposal could face robust political and legal opposition from those who perceive these amendments as jurisdictional overreach by the SEC.
Jones Day publications should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general information purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at our discretion. To request reprint permission for any of our publications, please use our “Contact Us” form, which can be found on our website at www.jonesday.com. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. The views set forth herein are the personal views of the authors and do not necessarily reflect those of the Firm.