When the Securities and Exchange Commission (SEC) first launched its consultation on updating the definition of an ‘exchange’ in January 2022, many debated whether this might include DeFi exchanges. On Friday, the SEC reopened the consultation and not only explicitly included DeFi, but asserted the existing definition often would likely cover DeFi as well. However, Chair Gary Gensler does not have the support of the two Republican SEC Commissioners, although the three Democrat Commissioners have a majority.
Yesterday the SEC also filed a lawsuit against the Bittrex crypto exchange. It follows a Wells notice sent to the Coinbase crypto exchange last month, warning of impending legal action regarding operating an unlicensed exchange because the SEC considers many of the cryptocurrencies traded as securities, as well as staking services.
Circling back to the definition of an “exchange”, a significant chunk of the newly published supplemental information is dedicated to DeFi. The SEC believes these systems qualify because it considers most crypto assets as securities and many DeFi protocols “likely meet the current criteria” for an exchange.
“Calling yourself a crypto platform is not an excuse to ignore the securities laws. Calling yourself a DeFi platform is not an excuse to defy the securities laws,” said Chair Gensler.
SEC Commissioners object
Commissioner Peirce said the expanded definition of an exchange renders “innovation kaput”. She wrote, “Stagnation, centralization, expatriation, and extinction are the watchwords of this release.”
Referring to the regulation of alternative trading systems (ATS), she noted that in the past, when the SEC had the option of fostering innovation or stifling it with an “inflexible and expansive” definition of “exchange”, it chose innovation. It did so by allowing early ATS systems to operate with no action letters and formalized regulations when there were sufficient numbers. Additionally, she believes the expanded exchange definition aims to solve problems that don’t exist.
Commissioner Uyeda’s objections had a similar theme. “One would expect evidence that there are important unaddressed problems manifesting themselves in this area,” he wrote. He rejects generalizations classifying crypto assets as securities, saying that each one of them has to be carefully analyzed under the Howey test.
Uyeda reviewed the key amendment to the definition of an Exchange. “The Commission has proposed replacing the word “orders” with “trading interest”, and “uses” with “makes available,” while adding “communication protocols” as an example of an established, non-discretionary method that would meet the second prong of the test. Two points are notable: the expansiveness of these combined changes and how ambiguous they are. “Trading interest” is a much vaguer concept than an “order.” “Communication protocols” imply a vast array of possibilities. “Makes available” appears to encompass anyone providing a service to the exchange that could be outsourced.”
He argues that disintermediation is a trend in other industries and is often beneficial. Hence he is concerned the expanded definition may obstruct innovation.
Who will the SEC pursue with DeFi?
One of the conundrums with DeFi exchanges is who is the regulated party. If the SEC wants to bring an enforcement action, who would they go after? The supplemental information outlines the Commission’s thinking.
The key factor is control over the DeFi protocol, which includes several elements such as ownership, financial interest, management and the ability to control access to the protocol, including user access or which securities are traded.
They are more likely to go after DAO members than the vendor that operates the marketplace unless that service provider also exercises or shares control. Significant holders of governance tokens get a special mention.
The paper discusses parties that “act in concert to perform, or exercise control or share control over, different functions of a market place”.
A software developer acting independently of the organization is less likely to be in concert.
The supplemental information emphasizes that the technology used, such as DLT, does not render an exchange as “incompatible with” existing securities laws.