SEC Shines Spotlight on Crypto Asset Securities Trading Systems and DeFi in Reopening Comments on Reg ATS Proposal

On April 14, 2023, the U.S. Securities and Exchange Commission (SEC) reopened the comment period — for the second time — for proposed amendments to Rule 3b-16 (the Proposal) under the Securities Exchange Act of 1934 (Exchange Act), which defines certain terms used in the statutory definition of “exchange,” excludes certain systems from the definition of exchange, and provides a functional test to assess whether a trading platform meets the definition of exchange. Along with reopening the comment period, the SEC issued a 166-page release (the DeFi Release) providing supplemental information and economic analysis focusing exclusively on the applicability of the Proposal to trading systems for crypto asset securities and trading systems that use distributed ledger or blockchain technology, including decentralized finance technology or protocols (DeFi Systems).

Commissioners Hester Peirce and Mark Uyeda voted against issuing the DeFi Release, with Commissioner Peirce writing a particularly strongly worded dissent.

The deadline for comments is the later of June 13, 2023, or 30 days after publication of the DeFi Release in the Federal Register.

Key Takeaways

The DeFi Release represents the SEC’s most direct attempt to regulate the crypto asset markets through its rulemaking process. The purpose of the DeFi Release is to clarify the application of the Proposal to crypto asset securities and DeFi Systems in response to numerous comments seeking such clarification. In doing so, the SEC poses 75 additional questions in the DeFi Release about trading systems, the majority of which relate to trading systems for crypto asset securities, including DeFi Systems, and the ability of such systems to comply with the Proposal and other applicable regulations. The SEC states that trading systems that trade crypto asset securities, including DeFi Systems, are not only contemplated by the Proposal but may already be scoped into the definition of exchange and have to, at a minimum, comply with Regulation ATS, including becoming a registered broker-dealer.

As a result, many trading systems may currently have a compliance obligation. To the extent the Proposal is adopted by the SEC, further clarification in the adopting release may help refine the scope of which systems are included. In addition, systems that support trading in all types of securities using non-firm trading interest would have to comply with Regulation ATS as well as systems that limit their activity to just trading U.S. Treasury securities. See Sidley’s previous Update on the Proposal for details.

Background

The Proposal, initially proposed in January 2022, would, among other things, amend Exchange Act Rule 3b-16 to expand the interpretation of the “exchange” definition to capture a broader universe of systems that the SEC believes constitute an exchange.¹ The SEC received nearly 200 comments in response to the Proposal, many of which commented on the ambiguity of the term “communication protocols” and requested further information on whether the SEC intended that term to include systems for trading crypto asset securities and DeFi Systems (and thus bring such systems within the scope of the term “exchange”).

The DeFi Release does not make any changes to the amendments proposed last year. Rather, it provides additional clarity regarding the application of the Proposal to DeFi Systems and other crypto asset securities systems, as described below.

Crypto Asset Securities and DeFi Systems

The key statements and positions of the SEC set forth in the DeFi Release include the following:

• Most Crypto Trading Platforms and DeFi Systems Are Exchanges Subject to the Proposal. The SEC states that “[b]ecause it is unlikely that systems trading a large number of different crypto assets are not trading any crypto assets that are securities,” these crypto trading platforms and DeFi Systems are “exchanges” under Exchange Act Rule 3b-16 and subject to the Proposal. This generally includes systems supporting trading pairs (i.e., where one asset (the base asset) is quoted in terms of another (the quote asset)).
• Functional Approach to Determining Exchange Status. The SEC states that notwithstanding how an entity may characterize itself or the technology it uses, the SEC will apply a “functional approach (taking into account the relevant facts and circumstances)” when assessing whether a system meets the definition of an exchange.
• DeFi Systems. The SEC states that many systems described as so-called DeFi Systems could be considered exchanges, given that they often rely on electronic messages between buyers and sellers so that they can agree to a trade without negotiation, including through the use of smart contract functionality. The SEC also notes that many DeFi Systems perform similar functions to those of a stock exchange, including allowing investors to discover prices, find liquidity, locate counterparties, and agree to the terms of a trade.
• DeFi and Custody. The SEC rejects the idea that because DeFi Systems do not involve the custody of assets, they cannot be considered exchanges under Rule 3b-16. Custodial services, according to the SEC, are not a relevant factor to whether a system is an exchange.
• Groups of Persons That Constitute an Exchange. The SEC notes that the “existence of smart contracts on a blockchain does not materialize in the absence of human activity or a machine (or code) controlled or deployed by humans.” Thus, the SEC identifies the following factors for determining whether a “group of persons”² (including a purportedly “decentralized” group) constitutes an exchange:
  • Acts in Concert – whether the persons “act in concert” to perform the functions/services that meet the definition of an exchange, including through a formal or informal agreement
  • Control – whether the persons “exercise control, or shares control, over the organization, financial, or operational aspects” of the functions/services that meet the definition of an exchange; control in this context includes traditional forms of control (e.g., ownership interest) and would include a person that can (individually or with others) determine or modify
    • the entering, storing, matching, or display of trading interest
    • the granting or limiting of access to, or otherwise determine or modify, the market or other data about securities and transactions available on the market place or facility, order types, order interaction procedures, execution priority, or negotiation protocols
    • the securities made available for trading or the access requirements and conditions for participation
    • who can, and in what amount, share in profits or revenues derived from the marketplace or facilities or by having the ability to enter into legal or financial agreements on behalf of or in the name of the marketplace or facilities
• “Group of Persons” and DeFi Systems. The SEC acknowledges that DeFi Systems may be comprised of many different persons acting independently, including developers, decentralized autonomous organizations (DAOs), validators or miners, and issuers or holders of governance or other tokens. Depending on the facts and circumstances, to the extent these groups act in concert or exercise control (or share control) over the functions that comprise an exchange, they would together constitute an exchange.
  • Developers – The SEC notes that a developer acting independently and separate from an organization who publishes or republishes code without any agreement with any person for that code to be used for a marketplace/exchange function “may be less likely” to be acting in concert with others to constitute an exchange.
  • Governance Token Holders – The SEC states that depending on the facts and circumstances, significant holders of governance or other tokens could be considered part of the group of persons constituting an exchange.
  • Service Providers/Vendors – A service provider or vendor could be part of the exchange where it exercises control, or shares control, over aspects of the marketplace or facilities.
  • Collective Responsibility – The SEC indicates that it is the collective responsibility of those with control or that act in concert to comply with the federal securities laws.
  • No Longer in Control – The SEC states that even if an organization deploys a smart contract (meeting the definition of an exchange) that the organization cannot significantly alter or control, the organization is nonetheless responsible for compliance with the federal securities laws for that marketplace.

In the Proposal, the SEC estimated that 22 systems would be required to register as a broker-dealer and comply with Regulation ATS based on the expanded definition of “exchange.”³ The SEC now states that this figure did not include several systems using non-firm trading interest and non-discretionary protocols to trade crypto asset securities, and as a result, the SEC revised the number of affected systems to a total of 35 to 46, which includes 15 to 20 additional systems that trade crypto asset securities.⁴

Economic Analysis

The economic analysis in the DeFi Release is noteworthy in that it essentially states that the SEC is unable to reliably assess the full impact of the Proposal, based on a lack of data about crypto asset securities markets. In particular, the SEC acknowledges that it has a “greater degree of uncertainty” in its analysis of the baseline, costs, and benefits of the Proposal with respect to crypto asset securities because of the lack of complete data on the functioning of the crypto asset securities market.

The SEC also acknowledges in the DeFi Release a number of negative implications that could result from the Proposal. For example, the SEC states that uncertainty about the application of the Proposal is likely to increase legal costs and decrease product development and innovation. The SEC also states that operating a trading system in a manner that complies with applicable regulations could “significantly reduce the extent to which the system is ‘decentralized’ or otherwise operates in a manner consistent with the principles that the crypto asset industry commonly refer to as ‘DeFi.’”⁵ The SEC further states that certain DeFi Systems would likely have difficulties complying with other rules under the Exchange Act, including Regulation SCI and the Fair Access Rule of Regulation ATS, and that such systems could choose to exit the market or restructure their technology and operations.

Dissenting Statements

Commissioner Peirce expressed deep concern with the DeFi Release’s failure to adequately resolve or respond to commenters’ concerns over the ambiguity and scope of the Proposal, noting the SEC’s “limited understanding of the area we are regulating.”⁶ Commissioner Peirce raised concerns with the breadth of who could be viewed as part of the group of persons constituting an exchange under the Proposal, including developers and large holders of tokens. Commissioner Peirce also expressed concern that the SEC’s interpretation of the Proposal presented in the DeFi Release may cause persons involved in DeFi Systems to operate outside the U.S. or exit the market.

Commissioner Uyeda’s similarly criticized the expansiveness and ambiguousness of the Proposal, calling attention to the fact that this ambiguity is likely compounded when the threshold question of whether any particular crypto asset is a security remains unsettled.⁷

Additional Notes

The DeFi Release also included some additional guidance and solicitation of comments not specific to DeFi Systems, including the following:

• Order and Execution Management Systems (OEMSs) – The SEC noted that it did not intend the Proposal to capture within the definition of an exchange the activities of brokers, dealers, and investment advisers who use an OEMS to carry out their functions (e.g., organizing and routing trading interest). The SEC noted that in some cases, an OEMS could perform exchange activities and solicited further comment on the use of OEMSs.
• Communications Protocol – In response to questions of commenters regarding the scope of a “communication protocol” (undefined under the Proposal) and concerns that this could include web chat providers and graphical user interfaces, the SEC solicited further comment on communication protocols and potentially substituting “negotiation protocols” instead.
• Makes Available – The SEC stated that it intended for the term “makes available” under the Proposal (i.e., to capture an entity that “makes available” the system that constitutes an exchange) to make clear that in the event a party other than the group/entity operating an exchange performs a function of the exchange, such party would be part of the scope of the exchange. In response to the concerns of commenters regarding the breadth of this term, the SEC solicited further comments.
• Portals for Multiple Issuers to Sell Their Securities – Commenters raised question as to whether the exclusion from the “exchange” definition for a system allowing an issuer to sell its own securities would extend to a system allowing multiple issuers to sell their own securities. The SEC solicited further comment on this question.
• Exchange Traded Fund (ETF) Sponsors – The SEC also solicited further comment on questions raised by commenters as to whether a system or portal used by an ETF sponsor to facilitate the creation and redemption of ETF shares would be viewed as an exchange under the Proposal.
• Compliance Date – Finally, the SEC solicited comment on the proposed compliance deadlines under the Proposal.

¹ For more information on the Proposal, please see Sidley’s previous update here.

² Under Section 3(a)(1) of the Exchange Act and Rule 3b-16, any “organization, association, or group of persons, whether incorporated or unincorporated” may constitute an exchange.

³ DeFi Release at 63-64. The SEC assumes such systems would choose to comply with Regulation ATS rather than register as a national securities exchange because of the lighter regulatory requirements imposed on ATSs.

⁴ DeFi Release at 64-65.

⁵ DeFi Release at 123.

⁶ Commissioner Hester Peirce, Rendering Innovation Kaput: Statement on Amending the Definition of Exchange (Apr. 14, 2023).

⁷ Commissioner Mark Uyeda, Statement on Supplemental Information and Reopening of Comment Period for Amendments to Exchange Act Rule 3b-16 regarding the Definition of “Exchange” (Apr. 14, 2023).