On April 14, 2023, the Securities and Exchange Commission (“SEC”) reopened the comment period and provided supplemental information on proposed amendments to Rule 3b-16 under the Securities Exchange Act of 1934 (“Exchange Act”), which defines certain terms used in the definition of “exchange” in Section 3(a)(1) of the Exchange Act. The reopening is primarily intended to address the significant comments received by the SEC in response to the initial proposal, many of which questioned the proposal’s application to trading systems that enable trading of crypto asset securities. The reopening comment period will end 30 days after its publication in the Federal Register or June 13, 2023, whichever is later.
- The SEC makes clear that, regardless of the proposal, if an organization, association, or group of persons meets the definition of “exchange” with respect to crypto assets that are “securities,” then it must register as a “national securities exchange” or “alternative trading system” (“ATS”).
- The SEC believes that decentralized finance (“DeFi”) systems already meet the existing definition of an “exchange” to the extent the crypto assets traded on their platforms are securities.
- Further, the SEC believes that the “group of persons” operating the DeFi system must determine who should register the “exchange” as a national securities exchange or ATS.
- This proposal and the reopening of the comment period are unlikely to change the crypto industry’s perception that seeking a path to registration will lead to enforcement action for crypto firms.
- The SEC also is seeking further comment on issues that drew significant reaction from the securities industry more broadly.
Background on Exchange and ATS Registration
Registration of “Exchanges”
Section 3(a)(1) of the Exchange Act defines “exchange” as “any organization, association, or group of persons, whether incorporated or unincorporated, which 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 as that term is generally understood, and includes the market place and the market facilities maintained by such exchange.” In turn, Section 5 of the Exchange Act requires such an exchange to register as a “national securities exchange” with the SEC, unless an exemption applies.
“Alternative Trading Systems” Registration and Rule 3b-16
In 1998, the SEC adopted Regulation ATS to create an exemption from registration as a “national securities exchange” for any organization, association, or group of persons that operated as an ATS and complies with Regulation ATS, which, among other things, requires that the ATS register with the SEC as a broker-dealer. The SEC concurrently adopted Rule 3b-16 under the Exchange Act to define certain terms used in the statutory definition of “exchange” in Section 3(a)(1) and similarly relied upon to define an ATS in Rule 300 of Regulation ATS.
Currently, Rule 3b-16 captures any organization, association, or group of persons that:
- brings together the orders for securities of multiple buyers and sellers; and
- uses 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 terms of a trade.
The Rule defines “order” as any firm indication of a willingness to buy or sell a security, as either principal or agent, including any bid or offer quotation, market order, limit order, or other priced order. In adopting Rule 3b-16, the SEC expressly declined to include systems displaying non-firm indications of interest such as indications of interest to buy or sell a particular security without either prices or quantities associated with those indications. If the organization, association or group of persons meets the Rule 3b-16 definition, it will meet the definition of an ATS under Rule 300(a) of Regulation ATS, so long as it does not:
- set rules governing the conduct of its participants effecting securities transaction (other than conduct for trading on the system); or
- discipline its participants other than by exclusion from trading.
January 2022 Proposal to Amend Rule 3b-16 and Expand Regulation ATS
In January 2022, the SEC released the proposal to expand the scope of Regulation ATS by, among other things, amending Rule 3b-16 to broaden the definition of certain terms used in the definition of “exchange” in Section 3(a)(1) of the Exchange Act by:
- replacing “orders” with “trading interest” to now capture the non-firm indications of interest that the SEC expressly excluded when adopting Rule 3b-16 (as noted above);
- replacing the phrase “uses established, non-discretionary methods” with the phrase “makes available established, non-discretionary methods” to capture systems that take a more passive role in providing participants the means and protocols to interact, negotiate, and come to an agreement;
- adding “communication protocols” as another example of an established, non-discretionary method (in addition to trading facilities or setting rules) that an organization, association, or group of persons can provide to bring together buyers and sellers with trading interest;
- shifting the focus from bringing together “orders” to bringing together buyers and sellers; and
- reducing the condition that the system bring together both multiple buyers and sellers, instead permitting a single buyer coupled with more than one seller to qualify (or one seller and multiple buyers).
The following chart reflects the key changes the proposal would make in defining those functions:
|Current Rule 3b-16
|Proposed Rule 3b-16
|Brings together the orders for securities of multiple buyers and sellers; and
|Brings together buyers and sellers of securities using trading interest; and
|Uses 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 terms of a trade.
|Makes available established, non-discretionary methods (whether by providing a trading facility or communication protocols, or by setting rules) under which buyers and sellers can interact and agree to the terms of a trade.
Notwithstanding the fact that the January 2022 proposal made zero mention of crypto or digital assets, many commentators noted the SEC’s broad statements at the time on whether crypto assets were “securities” (which have only been reinforced, if not expanded) and connected the broad and vague proposed amendments to Rule 3b-16 to the potential application of the proposal to crypto trading platforms, including DeFi systems.
Reopening Comments for the January 2022 Proposal to Address Crypto
In line with the SEC’s recent barrage of enforcement actions targeting the crypto industry, the reopening validated concerns voiced in comments to the initial proposal. The SEC notes in the reopening release that its purpose is to address the potential effects of the proposed amendments to Rule 3b-16 on trading systems for crypto asset securities and trading systems using distributed ledger technology (“DLT”), including various DeFi systems such as automated market makers (“AMMs”) and DeFi exchanges (“DEXs”).
Consistent with the SEC’s statements and other rule proposals potentially impacting the crypto industry, the reopening release reiterates the obvious: that both the existing rule and the proposed amended rule would apply to organizations, associations, or groups of persons meeting the definitional terms discussed above with respect to crypto assets that are “securities.” Of course, the SEC only refers back to prior SEC staff interpretations concerning when a crypto or digital asset is a “security,” without providing any of the more detailed guidance on the underlying issue that the crypto industry continues to seek. Despite the clear warning to current crypto asset exchanges and platforms of potential unregistered activity, the release conspicuously fails to acknowledge the industry perception that such a registration path does not exist for crypto.
Nonetheless, the SEC waited only a weekend before bringing a new enforcement action against a centralized crypto exchange for acting as an unregistered exchange, broker-dealer, and clearing agency. Further, the reopening comes on the heels of an announcement that the SEC issued a Wells Notice to one of the world’s largest centralized crypto exchanges covering a wide array of potential violations that also could implicate unregistered “exchange” activity.
The following are some of the key areas of interest for submitting comments:
Application to DeFi Systems and “Groups of Persons”
The SEC devotes a substantial portion of the reopening release to raising (but not necessarily responding to) comments on the potential application of the proposal to DeFi systems. Those comments noted the difficulty in applying regulations to DeFi systems on certain key points, including the fact that DeFi systems are structured based on the fundamental principle that no centralized person or persons controls the system. Rather, a DeFI system, such as a DEX, is intended to be a peer-to-peer marketplace where the tokenholders interact directly with each other to exchange crypto assets without the need for an intermediary.
Group of Persons
The SEC emphasizes the fact that the definition of “exchange” includes a “group of persons” providing a market place or facilities for bringing together buyers and sellers of securities or with respect to securities performing functions commonly performed by a stock exchange. While noting that it interprets “group of persons” under a facts and circumstances analysis, the SEC, without citing any substantive legal support (other than its own prior statements), provides that an important factor would be whether persons are “acting in concert” to establish and operate such market places or facilities or perform the functions commonly associated with a stock exchange. Further, the SEC also pulls in the concept of persons exercising control over all or certain aspects of a market place or facilities. This additional guidance provides about as much clarity for DeFi systems as the “group of person” term does by itself.
Interested parties should consider whether the SEC’s interpretation of “group of persons” is consistent with the intent of the Exchange Act, and the ambiguities that the SEC staff’s related explanatory statements in the release create. For instance, should two or more independent governance token holders who amass sufficient holdings to effectively control decisions of a decentralized autonomous organization (“DAO”) be viewed as a “group of persons” if they independently choose to vote in the same manner on a proposal for the DAO? What if 100 or more token holders voting together on a proposal for the DAO decide to vote in the same direction on the proposal? Moreover, the reopening economic analysis suggests that even validators and miners using the consensus mechanism to verify transactions on a blockchain could be roped in by the expanded “exchange” definition.
Assuming the SEC views such token holders as a “group of persons,” who should register as the exchange or seek ATS registration? In the SEC’s view, that is a problem for the “group of persons” to figure out, and if they fail to do so, then the whole group can be liable for acting as an unregistered exchange. Setting the legal theory aside, consider how, or if, this “group” would choose to defend itself or settle an enforcement action when it does not even view itself as a “group” who agreed to establish an exchange in the first place, and the group members likely do not even know the other persons in the group.
Communication Protocols and Passive DEXs
As noted above, DEXs are intended to be peer-to-peer marketplaces where tokenholders control their crypto wallets and trade directly with each other via smart contracts, and transactions are settled directly on the relevant blockchain. In this regard, the DEX generally takes a passive role in facilitating the ability for tokenholders to connect with other tokenholders to exchange crypto assets for other crypto assets. Moreover, different types of DEXs may involve other market participants or technology that may provide order books, utilize automated market maker algorithms, and liquidity providers. If the “group of persons” threshold can be met for a DEX, and if a crypto asset available to be exchanged through the DEX is a “security,” there is a question of whether a DEX could be an “exchange” under the current rules and, given the expansion to passive communication protocol systems, a much higher risk of that designation under the proposed rule.
Lack of a registration path
Comments to the initial proposal also addressed the “come in and register” pronouncement so often heard by those in the crypto industry from the SEC staff and Chairman Gensler, with a resounding: how? The reopening release provides little hope or clarity on this crucial issue and, instead, merely repeats the SEC staff’s view that the existing securities regulatory regime already provides the path. On this point, Commissioner Peirce’s statement opined that the reopening “offers no clarity as to how these systems are to be registered or why registration even makes sense.”
Lack of data on crypto systems and operations
The reopening also reflects the massive lack of reliable data and information that the SEC possesses regarding the crypto market generally. From a rulemaking standpoint, seeking to make definitive statements or projections on impacts to an industry and its investors based on limited and unreliable data is difficult to support. Of course, as part of the request for comments, the SEC seeks that data from the industry. However, given the SEC’s recent crypto crackdown and the industry perception that coming in to speak with the SEC is more likely to result in an enforcement action than registration, cooperation from the industry probably is not forthcoming. Commissioner Peirce also likely captured this sentiment, reflecting that “[t]oday’s Commission treats the notice-and-comment rulemaking process not as a conversation, but as a threat.”
Other general areas drawing significant comment
While the focus of the reopening is on the crypto industry, the proposal drew significant comment on the expanded definition generally. In particular, commenters noted that broadening the “exchange” definition could have a widespread impact on an unknown number of market participants that could find that they are captured by the new definition. To that end, the SEC is seeking additional comment from interested parties beyond just the crypto industry.
The SEC has been the subject of much criticism for its regulation by enforcement and regulation by staff interpretation approaches to the crypto industry, and rightfully so. However, the reopening release provides interested parties with some opportunity to directly address the SEC and seek regulatory clarity for the crypto industry in the US. The reopening also offers market participants a second bite at the apple on other areas that previously drew significant comment.