On January 26, 2022, the SEC proposed rule changes that would greatly expand the scope of Regulation ATS, the regulatory regime that governs alternative trading systems (“ATSs”). Applicability to the fixed income markets was the main headline (really, the only headline). But the proposed expansion to the definition of “exchange” goes well beyond that and would sweep in what the SEC refers to as “communication protocol systems.” In doing so, the proposal would broaden the scope of the ATS regime from a centralized construct to one in which a communication protocol system would be viewed as an exchange even if the developer merely “makes it available.”
In the SEC’s eyes, communication protocol systems can use various technologies and connectivity, but generally offer the use of non-firm trading interest and establish protocols to prompt and guide buyers and sellers to communicate, negotiate, and agree to the terms of the trade without relying solely on the use of orders. Puzzlingly, the SEC does not actually propose a definition for this new term. Communication protocol systems would be required to either register as exchanges (like NYSE or Nasdaq) or register as broker-dealers and comply with Regulation ATS.
There were zero references to crypto, blockchain, DeFi, or distributed ledger technology in the 654-page proposal. Nevertheless, the proposal makes clear that it applies to “trading any type of security.” SEC leadership, past and present, has repeatedly expressed the view that almost all crypto/tokens/digital assets are securities. This seems to imply, given these views previously expressed by SEC leadership, that the proposed new scope of the exchange definition could encompass certain DeFi protocols for crypto as well as protocols used and offered by centralized crypto exchanges (depending on specific details, of course).
Exchange, Trading Interest, and “Communication Protocol Systems”
The proposal would amend the definition of “exchange” in Rule 3b-16, including to add the new term and designation “communication protocol system.” The SEC offers no definition, but instead provides examples of communication protocol systems that would fall within with the revised definition, including request-for-quote systems, systems that display continuous non-firm interest such as a “stream axes,” conditional order systems, and negotiation systems.
Rule 3b-16 currently states that an organization, association, or group of persons shall be considered to constitute, maintain, or provide “a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange” if they:
(1) Bring together the orders for securities of multiple buyers and sellers; and
(2) Use established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade.
Under the proposal, performing an exchange function would be defined as:
(1) Bringing together buyers and sellers of securities using trading interest; and
(2) Making available established, non-discretionary methods (whether by providing a trading facility or communication protocols, or by setting rules) under which buyers and sellers can interact and agree to the terms of a trade.
The subtle but salient differences are:
(1) There would need not be multiple buyers and sellers on each side of the market, as is the case today (i.e., “many-to-many”) to be considered an exchange. Deleting the word “multiple” would mean that a single seller and multiple buyers would suffice, as would a single seller and a single buyer (i.e., one-to-many or one-to-one);
(2) What is “brought together” and what “interacts” under the proposal would be the buyers and sellers. Contrast that with “orders” being the focus under the current rule;
(3) The notion of “using trading interest” is added, which goes to the “non-firm” (e.g., exploratory or conditional) element of the proposal; and
(4) Instead of the exchange itself directly/actively “using” methods for “orders” interacting, one must only “make available” the facility or “communication protocol” for interaction.
Trading interest would mean an “order, as defined in Rule 3b-16, or any non-firm indication of a willingness to buy or sell a security that identifies at least the security and either quantity, direction (buy or sell), or price.” In broadening the definition of exchange to include trading interest, the SEC states “the use of firm or non-firm trading interest by a system should no longer be a factor in determining whether a system performs the function of a market place because both firm and non-firm trading interest can be used by a system with the same purpose and effect to bring together buyers and sellers of securities.”
The public comment link is available here, but will only be available for 30 days from the date on which the proposal is published in the Federal Register.
Order is defined as “any firm indication of a willingness to buy or sell a security, as either principal or agent, including any bid or offer quotation, market order, limit order, or other priced order.”
Nicholas J. LosurdoPartner
Karen UbellPartnerCo-Chair, Digital Currency & Blockchain