The amended definition could provide a new means for the SEC to regulate crypto platforms.

By Stephen P. Wink, Marlon Q. Paz, Naim Culhaci, Ian Irlander, and Deric Behar

We previously published a blog post on the set of proposed amendments (Proposal) issued on January 26, 2022, by the Securities and Exchange Commission (SEC) regarding the regulation of alternative trading systems (ATSs) that would, among other things, substantially expand the activities covered by the definition of an “exchange” as interpreted by Rule 3b-16 under the Exchange Act to capture “Communication Protocol Systems”. Whereas we previously offered our general views on the proposed expansion of definitions and resulting potential impact on the securities industry, now we turn specifically to the potential impact of the Proposal on platforms trading digital assets.

The SEC’s Proposed Expansions to the Definitions Used to Define “Exchange”

The Proposal would capture “Communication Protocol Systems” by expanding Rule 3b-16’s interpretation of the “exchange” definition in several meaningful aspects, including the following:

• Bringing Together Buyers and Sellers Using Trading Interest. The amended rule would replace the requirement that the platform “[bring] together the [firm] orders of multiple buyers and sellers” with the requirement that the platform “[bring] together buyers and sellers of securities using trading interest.” “Trading interest” in this context would be defined to include any firm orders as well 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.”
• Making Available Established Non-Discretionary Methods. The amended rule would also replace “uses established non-discretionary methods” with “makes available established non-discretionary methods.” This amended definition would significantly expand the scope of the rules to capture systems that passively provide a protocol or merely provide access to such protocol to “interact, negotiate, and come to an agreement” regarding a securities transaction.

The Reaction of Commissioner Peirce

Following the Proposal’s release, Commissioner Hester M. Peirce published a statement of dissent, asserting that while the Proposal is reasonable in its broad outlines, it is generally “too wide-ranging” and “too unwieldy to facilitate careful consideration.” In addition, commenting on the Proposal via a separate channel, Commissioner Peirce stated that “the proposal includes very expansive language, which, together with the chair’s apparent interest in regulating all things crypto, suggests that it could be used to regulate crypto platforms”. Commissioner Peirce further observed that “the proposal could reach more types of trading mechanisms, including potentially DeFi protocols.”

Decentralized and Other Platforms Trading Digital Assets Likely Captured by the Term “Makes Available”

While the Proposal does not expressly make any references to crypto or digital assets, the expansion of Rule 3b-16’s definitions could be viewed to bring within scope online portals that provide access to decentralized exchanges that trade digital assets and DeFi protocols, including aggregation-type services. Moreover, as further discussed below, the predicate for the application of these regulations is that securities are traded on the platform. Following the launch of a decentralized protocol, these decentralized platforms can operate autonomously, without the involvement of any central authority or enterprise, pursuant to the intrinsic logic of the smart contracts and the decentralized participation of platform users. And, such protocols generally permit the use of any compatible token without regard to whether such token may be deemed to be a security.

Online portals or user interfaces provide convenient access to such platforms, but the provision of such access, assuming securities are traded on the protocol, would arguably not be captured under the current version of Rule 3b-16 because it does not amount to the “use” of established non-discretionary methods to bring together buyers and sellers. On the other hand, the mere provision of such access would likely be captured under the expanded definition because it would qualify as “making available” established non-discretionary methods to bring together buyers and sellers (again, assuming securities are traded on the protocol).

In explaining its reasoning for its introduction of “makes available” the Proposal stated it believed that this term was preferable to the term “uses” because Communication Protocol Systems “can take a more passive role in providing to their participants the means and protocols to interact, negotiate, and come to an agreement.” The SEC further stated that the use of the term “makes available” is “intended to make clear that, in the event that a party other than an organization, association, or group of persons performs a function of the exchange, the function performed by party would still be captured.” While the SEC did not expressly describe decentralized crypto platforms, this reasoning could be extended to capture such platforms. Accordingly, if adopted, the Proposal could give the SEC a new means to regulate decentralized and other crypto service providers and platforms by regulating the user interfaces that provide access to them.

Threshold Question Remains Whether the Assets Being Traded are Securities

As noted above, the critical threshold question in analyzing whether a crypto platform or service provider is engaging in broker-dealer or exchange activity of course remains whether the digital assets that are being traded on it qualify as “securities”. If the assets that are being traded on a decentralized crypto platform are not securities, then the platform could not be deemed to be acting as an “exchange” pursuant to either the current or the proposed amended version of Rule 3b-16. Alternatively, if the assets being traded on the platform are securities, then the platform could potentially be required to comply with other requirements of the securities laws independently from the exchange registration requirement (e.g., the broker-dealer registration requirement or the requirement that every securities transaction be either registered or exempt from registration under the securities laws). In the absence of definitive guidance from the SEC, the question of whether digital assets that are available for trading on exchanges qualify as securities remains one riddled with uncertainty. Nonetheless, assuming that at least some of the assets that are traded on decentralized exchanges may be deemed “securities” the Proposal could provide the SEC with another means to regulate crypto platforms and other service providers.