Crypto Firms Brace For Impact As SEC Seeks To Redefine ’Exchange’

April 24, 2023
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The Securities and Exchange Commission (SEC) has re-opened a consultation on a proposal that would amend the definition of an "exchange" under US law. Meanwhile, the battle for regulatory jurisdiction over Ethereum continues.

The Securities and Exchange Commission (SEC) has re-opened a consultation on a proposal that would amend the definition of an "exchange" under US law. Meanwhile, the battle for regulatory jurisdiction over Ethereum continues.

In the past week, the SEC announced that it has re-opened a public comment period in response to an existing proposal to redefine what constitutes a securities exchange.

The proposal seeks to broaden the definition of "exchange" by making "trading interest" rather than "orders" the basis on which to regulate trading systems.

As noted by the SEC, “trading interest” would be defined as “any non-firm indication of a willingness to buy or sell a security that identifies at least the security and either quantity, direction (buy or sell), or price”.

The proposal also seeks to expand the definition of exchange to include "communication protocol systems" and other negotiation systems that bring together buyers and sellers.

In effect, this could apply to any platform that is used by more than one buyer of securities to communicate a willingness to buy to more than one seller of securities (or vice versa).

First put forward in January 2022, the proposal has already completed one round of public comment — from May to June last year — before being re-opened for further comment this week.

In a fact sheet attached to its re-opening announcement, the SEC reiterated that its existing rules continue to apply to crypto exchanges, including decentralised finance (defi) platforms, regardless of whether the proposal is adopted.

Gary Gensler, chair of the SEC, said he believes the additional information the agency submitted with the re-opening will help address comments on the proposal from all market participants, but particularly from crypto firms.

“Make no mistake: many crypto trading platforms already come under the current definition of an exchange and thus have an existing duty to comply with the securities laws,” said Gensler.

“Investors in the crypto markets must receive the same time-tested protections that the securities laws provide in all other markets.”

Gensler said he welcomes additional public comment on all aspects of the proposal, and has given market participants 30 days to submit their comments to the Federal Register.

The SEC’s proposed amendments relate to the wording of Exchange Act Rule 3b-16. For systems that fall under the exchange definition for the first time, they would be required to register as national securities exchanges, broker-dealers or alternative trading systems (ATS).

Between confusion and compliance

Wilson Sonsini Goodrich & Rosati, a US law firm that specialises in securities and intellectual property, said that if the SEC’s proposal is adopted, it will create an “expanded” and “somewhat ambiguous” definition of an exchange.

“This will likely give rise to further regulatory uncertainty for digital assets, especially until the SEC provides greater clarity regarding which digital assets are securities,” the law firm said.

In a list of firms and entities that the expanded definition could apply to, Wilson Sonsini included decentralised exchanges (DEXs), automated market makers (AMMs), software developers, order management and order routing systems and social media platforms.

As chief strategy officer at SOMA.finance, Jim Preissler is aiming to distinguish his platform as the first fully compliant, multi-asset DEX and issuance network for digital assets, tokenised equities and non-fungible tokens (NFTs).

Speaking to VIXIO, Preissler said the importance of the SEC’s proposal lies more in what constitutes a “security” under the Exchange Act, rather than what constitutes an exchange.

"If the SEC is determining that most digital assets fall under the securities classification, then it makes sense that platforms that trade them would consequently be determined to be exchanges,” he said.

“Therefore, those platforms must abide by the prior precedents, regulations and disclosures that have evolved to prevent conflicts, discourage bad behaviour and protect investors.”

Preissler added that although this may seem burdensome, it is part of the continuous process of compliance that firms trading in the securities should expect.

“This could upend much of the infrastructure and processes that the existing crypto companies have built to come into compliance,” he said. “While some may be reluctant to do this, these rules have been established for a reason."

The Ethereum conundrum

The debate as to whether “most” digital assets are securities was given another shot of uncertainty this week, thanks to an appearance by Gensler before the House Financial Service Committee.

Asked by committee chair Representative (R-NC) Patrick McHenry whether Ethereum, the world's second largest crypto-asset, is a security or a commodity; Gensler could not give a firm answer.

McHenry pressed Gensler to answer the question multiple times, and revealed that he had spoken to Gensler about the topic in private prior to the hearing.

“I'm asking a specific question, Chair Gensler. I said this in private — so this should be no shock to you that I’m asking this question — is ether a commodity or security?”

Gensler said he would not pass judgement on any individual crypto-asset during the hearing, so as not to “prejudge”.

McHenry reminded Gensler that he has already passed clear judgement on one crypto-asset, Bitcoin, which Gensler has said is a commodity, so why not offer the same clarity for Ethereum.

“You've taken 50 enforcement actions, and we're finding out as we go — as you file suit, as people get Wells notices — what is a security.

“Do you think it serves the market for an object to be viewed by the commodities regulator as a commodity and by the securities regulator as a security?”

Gensler again did not give a clear answer, and made only general references to the Howey Test criteria in response.

Specifically, Gensler pointed out several times that if an investor purchases an investment contract with the expectation of returns based on the efforts of others, it is a security.

Reading between the lines during the hearing, Preissler believes that what Gensler is doing — far from trying to bamboozle the industry into rule-breaking — is buying time for platforms and issuers to become compliant.

"Gensler is giving ethereum time to self-correct and decentralise, rather than just declaring it a security, which is possible under the current scenario,” said Preissler.

“While the crypto industry is jumping all over him, in fact he is giving them wiggle room. The majority clearly don't understand this, and may just end up hanging themselves with their own rope.”

Preissler added that Gensler's failure to offer a more definitive answer is a benefit to Ethereum, as the “hard choice” now would be for the SEC to declare Ethereum a security, and thus put even more platforms on the wrong side of the law.

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