October 11, 2023

SEC’s ATS Re-proposal Doubles Down on DeFi and Digital Asset Regulation

In April 2023, the SEC re-proposed amendments to Exchange Act Rule 3b-16 to expand the definition of what it means to be an exchange. When the SEC initially proposed these amendments in January 2022, there were zero direct references to crypto, blockchain, distributed ledger technology, or decentralized finance protocols (DeFi). However, the open-ended nature of the proposed new rule text attracted considerable attention and concern over potentially capturing digital asset exchanges and DeFi protocols within the purview of Regulation ATS. With a heavy focus on digital assets and DeFi in the SEC’s re-proposal and with a split 3-2 vote, the re-proposal confirms these concerns.

Our summary of the initial January proposal covers many of the technical aspects in scope and of discusses the requirements of Rule 3b-16 generally:

  1. The proposal applies to any crypto asset that is a security, including under an “investment contract” analysis. The SEC notes that “it is unlikely that systems trading a large number of different crypto assets are not trading any crypto assets that are securities.” Accordingly, in the SEC’s eyes, “these systems likely meet the current criteria of Exchange Act Rule 3b-16(a)” (emphasis added) and “some amount of crypto asset securities trade on New Rule 3b-16(a) Systems.” In each case, these systems would need to register as exchanges or as broker-dealers and alternative trading systems (ATSs). A spate of recent, high-profile enforcement actions appear to be in line with this view.
  2. The SEC seems to think that any entity that is an exchange can only support transactions in securities. The re-proposal states, “Market places or facilities of, and the functions performed by, national securities exchanges and ATSs trade only securities quoted in and paid for in U.S. dollars.” The SEC does not address how entities that trade both crypto security assets and non-security crypto assets should comply with the proposed rule. In other words, could an entity that trades crypto asset securities also trade BTC? Further, much of crypto trading occurs in trading pairs (e.g., selling BTC to buy ETH). In these cases, the transactions are frequently not quoted in or paid for with US dollars. If securities must be paid for in US dollars, what will happen to pair trading?
  3. The re-proposal clearly captures DeFi and distributed ledger transactions. The SEC states that “the exchange framework is based on the functions performed by a trading system, not on its use of technology.” Accordingly, the SEC indicated it will apply “a functional approach (taking into account the relevant facts and circumstances)” to determine whether the activities of a particular trading system meet the definition of an exchange. The SEC does not say much about how registration should occur for what are essentially decentralized software programs or who should be responsible for such registration. Indeed, the very point of DeFi is that it is decentralized, meaning it operates in an automated way according to a preestablished protocol, and there is no central group or actor with the ability to control or make decisions for the entire protocol or network. It thus remains unclear how the SEC expects these systems to come into compliance, a concern forcefully raised in Commissioner Hester Peirce’s dissenting statement to the re-proposal.
  4. The SEC makes the point that “an exchange can also exist where a market place or facilities are provided by a group of persons, rather than a single organization.” In this regard, the SEC indicated it looks at whether persons are acting in concert, are exercising control, or are sharing control to maintain or provide a marketplace or facilities to bring together buyers and sellers, whether pursuant to formal or informal agreements. The breadth of “acting in concert” opens the door to groups of unrelated parties potentially being considered to be performing exchange activities in the context of DeFi protocols. This includes network miners and validators, smart contract creators or other programmers, and potentially even users who display trading interest or parties that share in profits. The SEC also notes that ownership is a factor, which could open the door to mere ownership of a token (of a DEX, for example) being considered as exchange activity. The SEC did suggest that a software programmer acting independently who publishes code without any formal or informal agreement with any person for that code to be used for a marketplace or facilities for bringing together buyers and sellers of securities “may be less likely to be acting in concert to provide a marketplace” (emphasis added). However, this is far from definitive guidance, and given the SEC’s recent appetite for crypto enforcement, anyone participating in the general DeFi and crypto space should be wary. The SEC did at least ask several questions about the feasibility of registration for DeFi systems. The SEC has been on a proverbial and literal listening tour for five-plus years now. The agency should be providing answers and guidance instead of asking questions at this point.
  5. The SEC is considering potential alternatives to the initially proposed rule text. The initial proposal would have changed language in Rule 3b-16 from “uses established, non-discretionary methods” to “makes available established, non-discretionary methods.” The re-proposal asks a number of questions about this change and asks whether changing the rule text instead to “uses established, non-discretionary methods (whether by providing, directly or indirectly, a trading facility …” (emphasis in original) align more closely with prior guidance and focuses “the rule text on a function that a party performs in the provision of an established, non-discretionary method to bring together buyers and sellers.”
  6. Along the same lines, the SEC is considering defining or changing its use of the proposed undefined term “communication protocol.” The re-proposal asks whether communication protocols should be replaced with the term “negotiation protocols.” In this regard, the SEC proposed to define negotiation protocols as “a non-discretionary method that sets requirements or limitations designed for multiple buyers and sellers of securities using trading interest to interact and negotiate terms of a trade.” As proposed, the term “negotiation protocols” would focus more on nondiscretionary methods and is much narrower than the previously undefined term “communication protocols.” Interestingly, this potential narrowing does not necessarily keep the functional definition of exchange activity in the realm of “many to many” (i.e., multiple buyers and sellers). The main definitional change from bringing together “multiple buyers and sellers” (in the original ATS adopting release from 1998) to “bringing together buyers and sellers” (as re-proposed) remains in place.
  7. The SEC seeks further comment on proposed compliance dates for the rule. As many commenters noted, adoption of the rule would likely require a large number of entities to register as broker-dealers, inundating FINRA’s membership group with a flood of new broker-dealer applications at a time when new member applications often already extend well beyond the 180 days Rule 1017 allocates to FINRA. Given the practical challenges of registering potentially hundreds of new broker-dealers at the same time, the SEC would be wise to impose a long runway for coming into compliance. Alternatively, the SEC could provide reassurance that if an entity files its Form NMA before the compliance deadline, that applicant will have a grace period during which it will not face any action for non-compliance with registration.
  8. The SEC significantly enhanced its analysis of the costs of the rule in the Paperwork Reduction Act (PRA) and Economic Analysis (EA) sections. In the initial proposal, the PRA and EA did not seem to contemplate costs for entities that trade crypto asset securities or even consider that such entities could be in scope. This lack of analysis was perhaps the most likely grounds on which a court challenge to the proposal would have succeeded. By addressing this analysis in the re-proposal, the SEC seems keen to make a challenge along these lines more difficult.
  9. In a positive development for the mutual fund industry, the SEC confirmed it does not intend to capture order and execution management systems used by fund complexes to manage portfolio positions. The proposal is also not intended to apply to general chat functions, provided the chat function does not contain any type of structured messaging or prompts geared toward creating a securities transaction.

While the re-proposal sets its sights squarely on crypto and DeFi, the SEC appears to have at least considered some of the industry’s pushback in the initial comment process. One wonders if the SEC’s prior approach to crypto and digital assets will be altered in any way by more recent events, such as the Ripple summary judgment ruling or the Grayscale ruling, in which the court rejected the SEC’s disapproval of a spot bitcoin ETF.