SEC Inclusion of DeFi in ‘Exchange’ Definition Attracts Pushback – Ledger Insights
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 could include DeFi exchanges. On Friday, the SEC reopened the consultation and not only explicitly included DeFi, but argued that the existing definition will often cover DeFi as well. However, Chairman Gary Gensler does not have the support of the two Republican SEC commissioners, even though 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 Coinbase crypto exchange last month, warning of impending legal action regarding operating an unlicensed exchange because the SEC considers many of the cryptocurrencies traded to be securities, as well as betting services.
Returning to the definition of an “exchange”, a significant portion of the recently published additional information is dedicated to DeFi. The SEC believes these systems qualify because they consider most cryptoassets to be securities and many DeFi protocols “likely meet the applicable criteria” for an exchange.
“Calling yourself a crypto platform is not an excuse to ignore securities laws. Calling yourself a DeFi platform is not an excuse to defy securities laws,” said Chairman 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 key words for 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 without action letters and formalized regulations when there were sufficient numbers. In addition, she believes that the extended exchange definition aims to solve problems that do not exist.
Commissioner Uyeda’s objections had a similar theme. “One would expect evidence that there are important unaddressed issues manifesting in this area,” he wrote. He rejects generalizations that classify cryptoassets as securities, saying that each one must be carefully analyzed under the Howey test.
Uyeda reviewed the key change to the definition of a stock exchange. “The Commission has proposed replacing the word ‘orders’ with ‘commercial interest’ and ‘user’ with ‘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 noteworthy: the expansiveness of these combined changes and how ambiguous they are. “Commercial interest” is a much vaguer concept than an “order.” “Communication protocols” imply a large variety of possibilities. “Make available” appears to include anyone who provides a service to the exchange that can be outsourced.”
He argues that disintermediation is a trend in other industries and is often beneficial. He is therefore concerned that the extended definition may hinder 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 take an enforcement action, who would they go after? The additional 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 provider running the marketplace unless that service provider also exercises or shares control. Significant holders of governance tokens receive a special mention.
The article discusses parties that “act together to perform, or exercise control or share control over, different functions in a marketplace”.
A software developer who acts independently of the organization is less likely to be together.
The additional information emphasizes that the technology used, such as DLT, does not make an exchange “incompatible with” existing securities laws.
