Whereas the original proposal did not directly discuss digital assets, the reopening release is mainly focused on digital asset platforms.

On April 14, 2023, the Securities and Exchange Commission (SEC) issued a release amending portions of its earlier proposal to reinterpret the definition of an “exchange” and reopening the comment period for the proposed amendments (the Reopening Release.)

The SEC had issued a set of proposed amendments (the Original Proposal) on January 26, 2022, regarding the regulation of alternative trading systems (ATSs). The Original Proposal would amend Rule 3b-16 (Rule 3b-16) under the Securities Exchange Act of 1934 (the Exchange Act) to more expansively interpret certain terms used in the statutory definition of an “exchange” under Section 3(a)(1) of the Exchange Act. This reinterpretation would, among other things, cause the “exchange” definition to capture “Communication Protocol Systems”, which are not captured under the present version of Rule 3b-16. (See this Latham post for more information.)

The Original Proposal did not specifically reference digital assets, but its potential impact on the digital asset sector and particularly on decentralized digital asset trading (e.g., DeFi) protocols was indirectly raised by Commissioner Hester Peirce in a public statement and had become the topic of widespread discussion and numerous comment letters by industry participants. (See this Latham post for more information.)

The SEC stated that it is specifically amending the Original Proposal to respond to various comments it received regarding the application of the proposed amendments to digital asset platforms, including decentralized protocols. The bulk of the discussion in the Reopening Release is designed to support the SEC’s position that the “exchange” definition will apply to digital asset trading protocols that trade securities (including those that “purport” to be decentralized). However, the release also discusses other facets of the proposed reinterpretation of the definition and appears to signal receptiveness to carving out exceptions in certain areas. Below, we provide a short recap of the proposed amendments and highlight some key points in the Reopening Release.

Recap of Proposed Amendment

As discussed in greater detail in our prior post regarding the Original Proposal, the amended version of Rule 3b-16 would capture “communication protocol systems” by expanding Rule 3b-16’s definition of certain terms in the statutory “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.

Discussion of Digital Asset Platforms in Reopening Release

Applicability of Existing Exchange Definition

In line with SEC Chairman Gary Gensler’s view that the “vast majority” of digital assets are securities, the Reopening Release makes clear that the SEC believes digital asset exchanges are likely to meet the definition of an “exchange” under the present version of Rule 3b-16 “[b]ecause it is unlikely that systems trading a large number of different crypto assets are not trading any crypto assets that are securities….” While the SEC acknowledges that certain digital asset exchanges that are not captured by the current definition will be captured by the expanded definition, and, in fact, estimates that 15-20 such platforms will be captured in the cost-benefit analysis part of the Reopening Release, it does not critically discuss what types of platforms these are or what aspect of the reinterpreted definition will capture such platforms. As such the SEC does not seem to concede, as a general matter, that its proposed reinterpretation of the “exchange” definition is necessary to capture persons involved with digital asset platforms, including decentralized protocols. This position is further echoed in Chairman Gensler’s statement accompanying the Reopening Release in which he states: “[m]ake 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.”

In addition to stating that many such platforms have been captured by the exchange definition all along, the SEC repeatedly makes the point in the Reopening Release that the securities laws are “technology neutral” — both with respect to digital asset securities (i.e., “a crypto asset that is a security is not a separate type of security”) and with respect to exchanges (e.g.,“notwithstanding how an entity may characterize itself or the technology it uses, a functional approach…will be applied when assessing whether the activities of a trading system meet the definition of an exchange”).

“Makes Available”

As we discussed in our prior post, the main aspect of the Original Proposal that was understood to potentially have substantial impacts on digital asset platforms, and particularly on decentralized digital asset protocols, such as DeFi protocols, was the replacement of “uses” with “makes available” that is described above. This change was understood to potentially bring within the scope of the “exchange” definition various ancillary actors, such as online portals that provide a user interface for accessing decentralized exchanges that trade digital assets and DeFi protocols. Numerous comment letters took the position that expanding the “exchange” definition by amending Rule 3b-16 in this manner to capture persons that provide access to decentralized digital asset protocols that involve no intermediaries would exceed the parameters of the “exchange” definition under Section 3(a)(1) of the Exchange Act and thus the SEC’s statutory authority thereunder.

Interestingly, the Reopening Release does not expressly discuss what types of actors with respect to decentralized protocols would be captured by virtue of the proposed switch from “uses” to “makes available”. Indeed, the SEC’s discussion of this change in the Reopening Release does not make any references to digital asset platforms. Rather, the Reopening Release argues, on a more general basis, that the “exchange” definition under Section 3(a)(1) of the Exchange Act and specifically the reference to a “group of persons” therein is broad enough capture various actors involved with decentralized protocols. This approach again, seems to signal the SEC’s unwillingness to concede that its proposed amendments are necessary to capture persons involved with digital asset platforms, including decentralized protocols.

“Group of Persons”

In the Reopening Release, the SEC states that relevant factors in determining whether a “group of persons…constitutes, maintains, or provides an exchange” include whether they are “acting in concert” and whether they “control, or [share] control, over organizational, financial or operational aspects” of the platform. The SEC states that control is not limited to operational control and can be attributed to persons that individually or with others determine the securities available for trading, determine access requirements, determine shares in profits or revenue, or have the ability to enter into agreements on behalf of the platform. Finally, the SEC states that even if “an organization deploys a smart contract that the organization cannot significantly alter or control” it could be deemed to act as an exchange.

The SEC acknowledges the comments it received regarding the reinterpreted definition potentially being stretched to various ancillary actors in the decentralized protocol ecosystem (such as code developers, liquidity providers, website maintainers, miners, and validators). While not taking a position on whether the reinterpreted definition would in fact capture such persons, the SEC reiterates that such persons would only be considered an exchange if they meet the actual definition (i.e.,“if they constitute, maintain or provide a market place or facility that meets the applicable criteria”).

While the language of Section 3(a)(1) of the Exchange Act includes a “group”, it may be challenging to apply that to decentralized autonomous organization (DAO) structures, in which the intention to act in concert may be quite limited. Moreover, while others have applied state partnership law theories to DAOs (see, e.g., In the Matter of bZeroX, LLC), that reasoning could stray into law that is the province of the states. Of course, if the statute worked as the SEC states to capture these existing activities, one could wonder why reinterpreting the definition to reflect the “makes available” standard is necessary. The reason may be that while identifying a defendant in a DAO is legally challenging, identifying and holding user interface providers liable for any such violations is considerably easier (as those are typically run by enterprises rather than DAOs).

Potential Carve-Outs for Service Providers to Traditional Financial Services Sector

The SEC does not indicate any willingness in the Reopening Release to pare back the scope of amended Rule 3b-16 with respect to participants in the digital asset sector. However, it appears to indicate willingness to do so with respect to certain services providers to the traditional financial services sector.

One of the questions that the SEC asks is whether the term “communication protocols” should be replaced with “negotiation protocols.” This modification would presumably clarify that systems limited to communications among finance sector participants should not trigger the definition. The change from requiring firm orders under the present version of Rule 3b-16 to just requiring “trading interests” under the amended version would be a dramatic expansion. “Trading interest” would capture a message that identifies a security and indicates an interest in buying or selling (without an indication of price or size) even though it is not an actionable trade order. The SEC also asks for further detail regarding the roles of entities such as GUIs, web chat providers, primary market communication systems, software solutions, and trading desks — presumably to evaluate whether and to what extent they should be excluded from the scope of the expanded definition.

Conclusion

Even though the Original Proposal did not expressly mention digital assets at any point, the focus of the Reopening Release is certainly digital asset-related, as the SEC stated that it is reopening the comment period specifically to consider issues related to trading systems that trade digital asset securities. At least part of the SEC’s motivation may be to address the various concerns under the Administrative Procedures Act that were raised in comment letters by digital asset market participants. Although the SEC discusses application to the digital asset sector in depth, it does not signal any type of concession to commenters with respect to the decentralized nature of certain digital asset platforms. To what extent stakeholders, miners, or validators in a DAO could be characterized as “acting in concert,” and thus as a “group of persons” operating an “exchange,” remains to be seen.

The public comment period will remain open until the later of June 13, 2023 (60 days after the date of issuance), or 30 days after publication in the Federal Register.

This post was prepared with the assistance of Alex Dubose.