On January 26, 2022, the US Securities and Exchange Commission (SEC) proposed a rule (Proposed Rule) amending—and significantly broadening—a rule that defines certain terms used in the statutory definition of “exchange.”1 According to the SEC, the Proposed Rule is intended to “better protect investors and enhance cybersecurity by bringing more Alternative Trading Systems (ATS) that trade Treasuries and other government securities under the regulatory umbrella.”2 If the Proposed Rule is finalized, many entities—including cryptocurrency exchanges and other “communication protocol systems” using decentralized finance (DeFi) technology—could have to register with the SEC and be subject to new reporting and other regulatory requirements.
The Securities Exchange Act of 1934, as amended, (Exchange Act) defines an exchange as an entity that “constitutes, maintains, or provides 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,” and “includes the market place and the market facilities maintained by such exchange.” Absent an applicable exemption, exchanges must register with the SEC and are subject to certain reporting and regulatory requirements.
In 1998, the SEC issued Rule 3b-16(a) under the Exchange Act, which sets forth a two-part test for identifying an exchange subject to regulation: the entity must “(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 trade terms.”
The Proposed Rule sets forth several changes that would significantly broaden what constitutes an exchange for the purposes of SEC regulation as defined in Rule 3b-16(a). One notable change would re-define exchanges to include “communication protocol systems that make available for trading any type of security.” While the Proposed Rule does not explicitly reference cryptocurrency, other digital assets, DeFi, or related concepts, the Proposed Rule may have been intentionally drafted to subject cryptocurrency exchanges and DeFi platforms to SEC regulation.
These changes align with comments recently made by certain SEC Commissioners. SEC Chair Gary Gensler has expressed his belief that there is “a crypto market now where many tokens may be unregistered securities, without required disclosures or market oversight.”3 During a December 2021 event, Chair Gensler asked cryptocurrency exchanges to “come in, work with the SEC, get registered.” Commissioner Caroline Crenshaw, similarly, has noted the potential compliance issues that could stem from unregistered centralized bitcoin exchanges.4
Commissioner Hester Peirce’s dissenting opinion to the Proposed Rule appears to support the interpretation that the Proposed Rule is intended to include cryptocurrency exchanges and other DeFi platforms. Her statement emphasized the breadth of the Proposed Rule and how it could expand the definition of exchange to any trading venue for any type of security. She warned that the Proposed Rule may affect “those who operate any service that is designed to facilitate any communication between potential buyers and sellers of any type of security,” and encouraged them to read the release “[e]ven if you have nothing to do with government securities or even fixed-income, or with traditional securities.”5
The SEC also has already taken action consistent with Chair Gensler and Commissioner Crenshaw’s position. For example, in November 2021, the SEC informed a cryptocurrency exchange that it intended to bring an enforcement action if the company moved forward with a digital asset lending program that would allow certain customers to earn interest on select crypto assets. According to the company, the SEC did not specify why this product, which would have been similar to other established lending programs, involved securities and required registration.
However, substantial uncertainty in this area remains. Commissioner Peirce has repeatedly noted the large variety of digital assets and has emphasized the need for regulatory clarity and rules regarding whether cryptocurrency and other digital assets are securities. Confusion regarding whether digital assets are securities has also surfaced in court proceedings. In November 2021, a federal jury in Audit v. Fraser6 found that certain cryptocurrency-related products are not securities under the Exchange Act7 or under applicable state securities law. While there is no indication that the SEC will change its stance that at least some digital assets are securities, the Proposed Rule’s expanded definition of “exchange” may not encompass cryptocurrency exchanges and DeFi ventures if digital assets (or at least the specific digital asset at issue) are not considered to be securities.
Key takeaways
Should the Proposed Rule become final in its current form, the SEC likely would take the position that a cryptocurrency exchange or platform utilizing DeFi technology is required to register as an exchange and is subject to SEC regulation, provided the digital assets traded on the cryptocurrency exchange or DeFi platform qualify as securities under federal law. Companies—and particularly entities that could newly qualify as an exchange under the expanded definition—should consider submitting comments in response to the Proposed Rule. The comment period will end 30 days after the Proposed Rule is published in the Federal Register.
1 Amendments to Exchange Act Rule 3b-16 Regarding the Definition of “Exchange”; Regulation ATS for ATSs That Trade US Government Securities, NMS Stocks, and Other Securities; Regulation SCI for ATSs That Trade US Treasury Securities and Agency Securities, 17 CFR Parts 232, 240, 242, 249, Release No. 34-94062; File No. S7-02-22, https://us.eversheds-sutherland.com/portalresource/34-94062.pdf.
6 Audet v. Fraser, 332 F.R.D. 53 (D. Conn. 2019).
7 The jury applied the four-part test set forth by the US Supreme Court in SEC v. W.J. Howey, Co. Under the Howey test, an instrument is subject to SEC regulation if it involves (1) an investment of money; (2) in a common enterprise; (3) with a reasonable expectation of profits; (4) to be derived from the efforts of others. 328 US 293 (1946).
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