In March 2022, the U.S. Securities and Exchange Commission proposed rules that would greatly expand the Exchange Act definition of “dealer” and essentially kill the distinction between dealers and traders long-recognized by the SEC. The likely outcome is that most proprietary trading firms will need to register with the SEC as dealers and become members of FINRA or a national securities exchange (more on this later).
The Exchange Act's definition of dealer currently excludes a trader who “buys or sells securities…for such person’s own account…but not as a part of a regular business.” The proposal establishes quantitative and qualitative standards that seek to identify firms that have such a high degree of activity that, even though on a proprietary basis, they play a significant role in providing liquidity to the overall market. The quantitative standards triggering registration apply solely to government securities dealers, but any person or firm that has or controls total assets of at least $50 million and satisfies the proposed qualitative standards indicating they are “dealer-like” will need to register.
The scope of the proposal is vast — all securities, including equities, fixed income, government securities, and, wait for it…digital asset securities. The SEC’s focus is on “market participants who engage in a routine pattern of buying and selling securities for their own account that has the effect of providing liquidity. Said differently, for market participants engaging in any of the activities identified by the qualitative standards of the [proposal], liquidity provision is not incidental to their trading activities. Rather, these persons are ‘in the business’ of buying and selling securities for their own account and providing liquidity as part of a regular business.”
The proposed qualitative standards are below, any one of which would be sufficient to push what today is viewed as a non-registered trading to the category of registered (and regulated) dealer activity “regardless of whether the liquidity provision is a chosen consequence the activity."
- Routinely making roughly comparable purchases and sales of the same or substantially similar securities in a day;
- Routinely expressing trading interests that are at or near the best available prices on both sides of the market and that are communicated and represented in a way that makes them accessible to other market participants; or
- Earning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or from capturing any incentives offered by trading venues to liquidity-supplying trading interests.
In addition to covering proprietary traders in equities, fixed income, and other traditional financial assets, the proposal may lead to a dealer registration requirement for automated market makers (AMMs) and other liquidity providers in the cryptocurrency and DeFi space.
THE PROPOSAL SHOULD NOT BE READ IN A VACUUM
Coupled with the SEC’s recent proposal to amend the definition of “exchange” in Exchange Act Rule 3b-16 (“exchange proposal”), this dealer proposal is central to the SEC’s goals of increasingly expanded regulatory reach, including additional market participants (like “communication protocol systems” and this broader universe of securities dealers), both in traditional financial markets and beyond (including crypto and DeFi). Unlike this dealer proposal, the SEC’s exchange proposal scope did not explicitly mention “digital asset securities,” referring instead generically only to “all securities” being covered. Under the exchange proposal, any organization meeting the proposed, revised definition of exchange would need to register as an exchange, or alternatively register as a broker-dealer, become a FINRA member, and file Form ATS.
The revised definition of exchange would include “making available” established non-discretionary methods under which buyers and sellers could interact (including by providing a communication protocol system). Communication protocol system is surprisingly not defined in the proposed rule, but the non-dispositive examples provided are broad enough to include organizing the presentation of trading interest or setting minimum criteria for messages. An organization would also no longer have to use non-discretionary methods of providing a trading facility or setting rules. Rather, it need only “make them available” for others to use. The foreseeable effect here is that crypto exchanges and even DeFi protocols that function as decentralized exchanges (DEXs) may be covered by the proposed rule, if adopted.
Between the exchange and dealer proposals, a staggering number of companies and software developers in the crypto and DeFi space may become subject to the SEC’s broker-dealer framework, including registration with the SEC and FINRA membership. In a certain way, this outcome would be consistent with SECs long enunciated approach that it will employ the existing laws and regulatory framework to new technologies.
The SEC took these steps around the time when the White House issued its Executive Order (“EO”) for a national strategy for crypto and digital assets. Pursuant to that order, the White House’s official position is that “we must reinforce United States leadership in the global financial system and in technological and economic competitiveness, including through the responsible development of payment innovations and digital assets.” The SEC published the exchange proposal prior to the EO, but published the dealer proposal after the EO. The EO also includes a provision clearly directing interagency coordination for its implementation.
The SEC has received harsh criticism for the agency’s perceived approach to backdooring its recent steps to regulate crypto and DeFi activity. One must wonder if the agency specifically referenced digital asset securities in the dealer proposal (albeit it in a single footnote) after hearing this criticism stemming from the exchange proposal and seeing the writing on the wall via the EO.
ONE PROBLEM (OF SEVERAL)
Neither of these proposals are as straightforward as they seem. Putting aside the discussion of whether this is the appropriate policy approach, there is a glaring practical/feasibility problem with attempting to apply the existing broker-dealer, ATS, and FINRA membership frameworks to various DeFi protocols, DEXs, and AMMs — namely, who registers and who is deemed responsible for the resulting activity? These protocols consist largely of self-executing code that runs on a distributed ledger. Users proactively choose to avail themselves of the services these protocols offer. In fact, the entire point of these protocols is that they are decentralized, i.e., without a central actor. In these cases, it is not clear who the SEC would hold accountable for the registration or FINRA membership burdens or legal and compliance responsibilities. Similarly, if the SEC were to bring an enforcement action against a DEX or AMM or try to examine it, against/to whom would that apply? There are novelties to decentralization that do not fit neatly within existing centralized regulatory frameworks, yet the SEC seems intent on shoehorning things in that manner.
The other problem the SEC faces with this approach is that before it brings any action against an organization for unregistered exchange or broker-dealer activity, it will need to establish that a cryptocurrency or token exchanged, traded, or otherwise intermediated by that organization was a security. Prior SEC statements are instructive in this regard, but also serve to paint the SEC into a corner. For instance, in the past certain SEC personnel in leadership positions stated that the agency will not regard bitcoin or ether as a security, noting that each were “sufficiently decentralized” such that “purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts.” 1 That same speech indicated that “Over time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required.” In a recent public interview, SEC Chairman Gary Gensler went so far as to identify bitcoin as a commodity, rather than a security, but he did not mention other crypto assets.
A KEY MISSING PIECE
Unfortunately, the SEC has not articulated any metric as to what the necessary degree of decentralization is in order to, for example, overcome the “solely from the efforts of others” prong of Howey and, therefore not be viewed as an investment contract and, likewise, not be considered a security. In 2019, the SEC’s “FinHub” staff published a framework and series of open-ended questions and factors through which digital assets could be analyzed to help determine security status. The framework lacked any clear guidance, boundaries, or limiting principles, however, that would help the industry analyze assets using the framework in a consistent way. Moreover, enforcement actions from the SEC often provide little or no guidance in this area for the industry. Instead, the SEC settlements typically make blanket assertions about the security status of the coins trading on our through the particular venue or intermediary that is subject to alleged unregistered activity. The SEC also often fails to “show its math” regarding how they arrived at the conclusion.
There is a key, underappreciated nuance to this entire dynamic, however. Many in the industry are pleading with the SEC to issue clear and reliable guidance as to when a coin is or is not a security. On the surface, that is an entirely sensible request. But the SEC, as the agency of investor protection, is somewhat constrained in this regard. As has happened with individual actions in the past, if the SEC has alleged that a particular coin is a security, the price of that coin has decreased dramatically as investors simultaneously rush to the exit. Imagine if the agency were to prescribe broad guidelines as to when a cryptocurrency was a security, and those guidelines likely applied to perhaps 20 or 200 individual coins or a significant percentage of the assets and projects in the approximately trillion dollar cryptocurrency industry. Investor losses would be staggering.
As a way to mitigate this potential fallout, the SEC could emphasize a long runway, grace period, or safe harbor for compliance in any proposal, such as the one proposed by SEC Commission Hester Peirce.2 Perhaps a better and more pragmatic approach would be for the SEC to issue a concept release outlining the agency’s position in a non-binding way, inviting comment, and affording industry participants and investors ample time to assess, comment, and adjust their positions and behavior before any eventual rulemaking becomes operative. Any one of these approaches has legitimate merit and would represent a step forward. Nonetheless, the agency is in a tight spot that makes the approach of providing such guidance — which seems like obvious step at first glance — far less conspicuous.
The SEC recently reopened the comment period for the exchange proposal, post-White House EO and potentially in recognition of the many comments the SEC received on the proposal (including many that opposed the SEC’s broad and undefined expansion of its regulatory authority into the crypto and DeFi space). In light of the national strategy espoused in the EO, the SEC may be rethinking its approach. Those with a vested interest in either the dealer or exchange proposals should continue to weigh in on these rulemakings.
Concurrently, the growth of the industry has garnered Congressional attention, and there are a number of bills on Capitol Hill that seek to provide regulatory clarity in this space. One such bill — the Lummis-Gillibrand bill (also known as the Responsible Financial Innovation Act (RFIA)) — would characterize all digital assets that are not specifically securities as “ancillary assets” that would be regulated as commodities, placing the authority to regulate them with the CFTC. The RFIA would also allow broker-dealers to custody such ancillary assets and create tax reporting rules applicable to broker-dealers, while still providing that the SEC continue to have jurisdiction over broker-dealers and their related activities. The SEC’s current approach has also drawn attention from the United States House of Representatives Committee on Appropriations, which in recent statements noted with respect to digital assets: “The Committee recognizes that digital assets can drive innovation in the financial services sector. New financial products require clear pathways and regulatory structures for stakeholders, developers, and investors. The Committee is concerned that enforcement action in the absence of regulatory clarity invokes confusion in the growing sector. The Committee encourages the SEC to issue public guidance that promotes U.S.-based innovation.”
TIME WILL TELL (EVEN IF THE SEC DOESN’T)
If the SEC’s ambitious regulatory agenda is any indication, the agency will likely adopt both of these proposals by year-end. We eagerly wait to learn whether the SEC will revise the final rulemakings to better align them with directives in the EO or bills on Capitol Hill or industry feedback or practical considerations that make the crypto and DeFi space significantly different from traditional and centralized finance. In either case, the SEC seems to be inching closer toward greater oversight of the crypto and DeFi space, even if not in an overt manner.
 See Bill Hinman, Director, Division of Corporation Finance, “Digital Asset Transactions: When Howey Met Gary (Plastic),” (June 14, 2018).
Commissioner Peirce’s proposed safe harbor for tokens would “provide network developers with a three-year grace period within which, under certain conditions, they can facilitate participation in and the development of a functional or decentralized network, exempted from the registration provisions of the federal securities laws.” See https://www.sec.gov/news/public-statement/peirce-statement-token-safe-harbor-proposal-2.0.