Expanded Definition of “Exchange” and SEC Regulation of Crypto Platforms


The modified definition could provide a new means for the SEC to regulate crypto platforms.

Us previously published a blog post on the set of proposed modifications (Proposal) issued on January 26, 2022, by the Securities and Exchange Commission (SEC) with respect to the regulation of alternative trading systems (ATS) which, among other things, would substantially expand the activities covered by the definition of “exchange” such as interpreted in Rule 3b -16 under the Exchange Act to capture “Communication Protocol Systems”. While we previously provided our general views on the proposed expansion of definitions and the resulting potential impact on the securities industry, we now address specifically the Proposal’s potential impact on platforms that trade digital assets.

The SEC’s proposed expansions to the definitions used to define “exchange”

The Proposal would capture “Communication Protocol Systems” by expanding Rule 3b-16’s interpretation of the definition of “exchange” in several significant respects, including the following:

  • Bring buyers and sellers together using the commercial interest. The amended rule would replace the requirement that the platform “[bring] together the [firm] orders from multiple buyers and sellers” with the requirement that the platform “[bring] brings together buyers and sellers of securities using trading interests”. “Business interest” in this context would be defined to include any firm order, as well as “any non-firm indication of willingness to buy or sell a security that identifies at least the value and amount, direction (buy or sell), or price.”
  • Making available established non-discretionary methods. The amended rule would also replace “uses established nondiscretionary methods” with “makes available established nondiscretionary methods.” This amended definition would significantly expand the scope of the rules to capture systems that passively provide a protocol or simply provide access to such a protocol to “interact, negotiate, and reach agreement” with respect to a securities transaction.

Commissioner Peirce’s reaction

Following the release of the Proposal, Commissioner Hester M. Peirce published a statement of dissent, stating that while the Proposal is broadly reasonable, it is generally “too broad” and “too unwieldy to facilitate careful consideration.” Furthermore, by commenting on the Proposal through a channel, Commissioner Peirce stated that “the proposal includes very broad language that, coupled with the President’s apparent interest in regulating everything cryptocurrency, suggests it could be used to regulate cryptocurrency platforms.” Commissioner Peirce further noted that “the proposal could reach more types of trading mechanisms, including potentially DeFi protocols.”

Decentralized platforms and others that trade digital assets likely to fall under the term “makes available”

While the Proposal makes no express reference to crypto or digital assets, expanding the definitions of Rule 3b-16 could be seen to include online portals that provide access to decentralized exchanges that trade digital assets and DeFi protocols, including the aggregation type. services. Furthermore, as discussed below, the prerequisite for the application of these rules is that the securities are traded on the platform. Following the launch of a decentralized protocol, these decentralized platforms can operate autonomously, without the involvement of any central authority or company, in accordance with the intrinsic logic of smart contracts and the decentralized participation of platform users. And such protocols generally allow the use of any supported token regardless of whether that token can be considered a value.

Online portals or user interfaces provide convenient access to such platforms, but the provision of such access, assuming securities are traded in the protocol, would likely not be included in the current version of Rule 3b-16 because it does not equals “use” of established non-discretionary methods of bringing buyers and sellers together. On the other hand, the mere provision of such access would likely fall under the expanded definition because it would qualify as “make available” established non-discretionary methods of bringing buyers and sellers together (again, assuming securities are traded on the protocol).

In explaining its reasoning for the introduction of “makes available”, the Proposal stated that it believed this term was preferable to the term “uses” because Communication Protocol Systems “can take a more passive role in providing their participants with the means and protocols for interacting, negotiating, and reaching an agreement.” The SEC further stated that the use of the term “makes available” is “intended to clarify that, in the event that a party other than an organization, association, or group of perform a function of the exchange, the function performed by the group would still be captured.” While the SEC did not expressly describe decentralized crypto platforms, this reasoning could be extended to capture such platforms. Consequently, if adopted, the Proposal could provide to the SEC a new means to regulate decentralized providers and platforms and other cryptographic services by regulating the interfaces it is user who provide access to them.

The threshold question remains whether the assets being traded are equities

As noted above, the critical threshold question when analyzing whether a crypto platform or service provider is engaging in brokerage or exchange activity remains, of course, whether the digital assets traded on it qualify as “securities.” . If the assets being traded on a decentralized crypto platform are not securities, then the platform could not be considered to act as an “exchange” under the current or proposed amended version of Rule 3b-16. Alternatively, if the assets being traded on the platform are securities, then the platform could potentially be required to comply with other securities law requirements independent of the exchange’s registration requirement (e.g, the broker-dealer registration requirement or the requirement that all securities transactions be registered or exempt from registration under securities laws). In the absence of definitive guidance from the SEC, the question of whether digital assets that are available for trading on exchanges qualify as securities remains fraught with uncertainty. Nonetheless, assuming that at least some of the assets traded on decentralized exchanges can be considered “securities,” the Proposal could provide the SEC with another means of regulating crypto platforms and other service providers.

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