The U.S. Securities and Exchange Commission (the SEC or the Commission) voted on Friday, April 14, 2023, to reopen the comment period for previously proposed amendments to Rule 3b-16 under the Exchange Act of 1934 (the Exchange Act).[1] Rule 3b-16 defines “exchange” as used in Section 3(a)(1) of the Exchange Act.[2] If adopted, the proposed amendments would expand the definition of “exchange” to capture a broader scope of trading platforms.
In reopening the comment period, the Commission provided additional information on the proposed scope of Rule 3b-16 via a supplemental release (the Reopening Release), and reiterated the current rule’s applicability. The Reopening Release doubles down on the SEC’s position that the existing Exchange Act rule framework applies to certain crypto and digital asset trading platforms that use distributed ledger technology (DLT), blockchain technology, or decentralized finance (DeFi)[3] (hereafter generally referred to as “crypto market participants”). Further, the SEC clarified in detail how amended Rule 3b-16 would apply to additional crypto market participants based on the functions being performed by those participants. The Commission initially proposed these amendments in January 2022 (the Proposing Release)[4] and reopened the comment period once before in May 2022. The Commission will now accept additional comments to the Reopening Release until June 13, 2023.
Key Takeaways
Application to crypto market participants. The SEC noted that it received many comment letters in response to the Proposing Release that, among other things, requested additional information regarding whether and if Rule 3b-16, as amended, would apply to crypto market participants. The SEC explained that it reviewed the comments and intended to publish the Reopening Release (and reopen the comment period) to generally affirm that the Exchange Act’s registration requirements[5] are currently applicable to crypto market participants, as the amended Rule 3b-16, if adopted, would be.
Members of the crypto and digital asset industry have repeatedly called for the SEC to adopt reasonable rules to govern the crypto industry,[6] clarify the securities regulatory framework that is applicable to crypto and/or digital assets,[7] or, perhaps, both. The Reopening Release provides the industry with both regulatory clarity and certainty with regard to the SEC’s position on rule applicability.
In support of the Reopening Release, SEC Chair Gary Gensler published a statement that, in relevant part, underscored the SEC’s position affirming the applicability of existing securities laws to the crypto and digital asset industry. Chair Gensler affirmed that “the vast majority of crypto tokens are securities” and, quoting late Supreme Court Justice Thurgood Marshall, asserted that “Congress’s purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.” Chair Gensler also concluded that many crypto market participants already meet the criteria of the current “exchange” definition and are, therefore, operating unregistered national securities exchanges in violation of Section 5 of the Exchange Act. Chair Gensler cautioned crypto market participants that “ignor[ing] the securities laws” does not mean that such laws are inapplicable.[8] In short, noncompliance does not mean inapplicability.
A note for broker-dealers. The Reopening Release notes that a broker-dealer operating an alternative trading system (ATS) could face liability under Section 5 of the Securities Act of 1933 (the Securities Act) for facilitating the sale of a security that was not issued pursuant to registration with the SEC or in reliance on an exemption from registration such as complying with Regulation ATS.[9] A broker-dealer seeking to rely on this exemption must have a reasonable basis to believe that a selling customer’s part of the transaction is exempt from Section 5 of the Securities Act in order to rely on this exemption. Further, a broker-dealer must conduct a “reasonable inquiry” into the facts surrounding the proposed unregistered sale of securities before facilitating the transaction. The Commission reminds broker-dealers that rely on this exemption of the exemption’s limitations and of their gatekeeping obligations.[10]
Single seller exclusion. If adopted, the Proposing Release would codify the existing exclusion from Rule 3b-16 for systems that allow an issuer to sell its securities to investors.[11] As the Reopening Release explains, while such systems may involve the sale of securities to multiple buyers, the issuer is the sole seller of the securities. Therefore, such systems would not fall within the “exchange” definition.
Proposed Amendments and Supplemental Information
Organizations, associations, or groups of persons that meet the definition of “exchange” under Section 3(a)(1) of the Exchange Act must register with the SEC as a national securities exchange unless an exemption applies. Currently, Exchange Act Rule 3b-16(a) states that an organization, association, or group of persons would be considered to be an “exchange” for purposes of Section 3(a)(1) if such organization, association, or group of persons: (1) brings together the orders for securities of multiple buyers and sellers, and (2) uses established, nondiscretionary 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.
If the Proposing Release is adopted, Rule 3b-16(a)(1) and (2) would be revised as follows:
- Brings together buyers and sellers of securities using trading interest.[12]
- Makes available established, nondiscretionary methods (whether by providing a trading facility or communication protocols, 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 SEC stated that the use of the plural terms “buyers and sellers” in Rule 3b-16(a)(1)—and the statutory definition of “exchange” in Section 3(a)(1), which uses the terms “purchasers and sellers”—makes sufficiently clear that an exchange need only have more than one buyer and more than one seller participating on the system to meet this prong.
Together, these amendments would both alter the test used to determine whether a trading platform meets the “exchange” definition and broaden the scope of platforms that would be required to register as an exchange. Further, it would possibly make enforcing the rules against noncompliant market participants more straightforward and efficient for the SEC.
Applicability to Crypto Market Participants
In addressing crypto market participants’ comments to the Proposing Release, the SEC used the Reopening Release to clarify its position regarding the applicability of the Exchange Act’s exchange registration requirement to crypto and digital asset securities and, in turn, crypto market participants. The summary below highlights certain of those comments and the SEC’s response.
The Existing Legal Framework Already Applies to Crypto and Digital Assets
Commenters to the Proposing Release expressed concerns over the applicability of Rule 3b-16 to crypto market participants. For instance, some commenters noted that the Proposing Release did not contain any explicit references to crypto market participants. Others asserted a view that there is ongoing regulatory uncertainty as to which crypto assets are securities and, therefore, the SEC should delay any action until this uncertainty is resolved. Still, others stated that the existing regulatory framework is incompatible with crypto technology more broadly and, therefore, should not apply to crypto market participants in its current form. In response, the SEC underscored that activities involving digital assets are within the scope of existing securities laws where the digital assets are “securities.” Accordingly, both existing and proposed Exchange Act rules govern marketplaces that facilitate the trading of securities, even where they may also facilitate the trading of non-securities.
Rule 3b-16—and the Exchange Act—Are Technology Neutral
“Technology neutral” is a constant and consistent theme throughout the Reopening Release. The SEC stated that the Exchange Act (and the rules and regulations thereunder) applies to trading in any type of security, regardless of the underlying technology. The Reopening Release conveys several statements in support of the viewpoint that existing exchange registration requirements are applicable to crypto market participants regardless of the differences in technology used by those platforms.
The SEC cautions crypto market participants to look to the function and economic realities of their conduct when evaluating whether their businesses are subject to Exchange Act requirements. Specifically, the Reopening Release states: “[n]otwithstanding how an entity may characterize itself or the technology it uses, a functional approach (taking into account the relevant facts and circumstances) will be applied when assessing whether the activities of a trading system meet the definition of an exchange.”[13] Accordingly, any “organization, association, or group of persons that uses any form or forms of technology (e.g., DLT, including technologies used by so-called ‘DeFi’ trading systems, computers, networks, the Internet, cloud, telephones, algorithms, a physical trading floor)” for the purposes of functioning as a marketplace for bringing together purchasers and sellers of securities, or for otherwise performing functions commonly performed by a stock exchange, may constitute an “exchange” that is required to register as a national securities exchange or rely on an exemption such as Regulation ATS.
Crypto Market Participants and Traditional Exchanges Are More Similar Than Different
Commenters focused on the differences between crypto market participants and traditional national securities exchanges in support of the argument that the existing legal framework is inapplicable to the crypto and digital asset industry. The SEC emphasized the similarities between the activities performed by crypto market participants and those performed by traditional exchanges in determining whether certain conduct meets the definition of exchange. To this end, the SEC’s analysis seemingly disregards corporate structure and technology and instead prioritizes the functions of the entities, including, without limitation, whether a person or entity is establishing, maintaining, and or providing trading facilities. Irrespective of whether the marketplace or facility is operated via DeFi, decentralized autonomous organization (DAO), DLT, or a combination of the above, the analysis as to whether the marketplace or facility is governed by the Exchange Act is based on its actual function.[14]
To illustrate that the current regulatory framework already applies to crypto market participant activities, the Reopening Release enumerated features of current DeFi systems that are analogous to traditional stock exchanges, including:
- DeFi trading systems can be used to (1) provide price discovery mechanisms, (2) assist in liquidity sourcing, (3) help investors locate counterparties, or (4) provide mechanisms to agree upon terms of trade.
- Certain DeFi systems rely on electronic-based messaging systems that bring together buyers and sellers of securities so that they can agree upon terms of a trade without negotiations. Such messages could constitute an “order” to buy or sell securities, as currently defined by the Exchange Act and related SEC rules, if it is a firm willingness to buy or sell a security.
- Smart contract functionality can establish nondiscretionary method(s) under which orders of multiple buyers and sellers interact with each other.
The “Exchange” Definition May Apply to Decentralized Systems
Multiple commenters argued that applying the “exchange” definition and the registration requirement to decentralized systems would be inappropriate as those systems lack a central operator or intermediary as a core feature. The SEC disagreed with this argument, stating, “[t]he existence of smart contracts on a blockchain does not materialize in the absence of human activity or a machine (or code) controlled or deployed by humans.”[15]
The SEC also clarified that—while it is common for a single organization to provide a marketplace or trading facility—a group of persons can also provide a marketplace or facility, including persons exercising “control” over the marketplace or facility.[16] This is a reminder that there is no legal or statutory definition of “decentralized” and, to the extent that conduct can be traced back to an individual or group of individuals, then those individuals may be held responsible. The SEC concluded that an organization that deploys a smart contract that may not be significantly altered or controlled by the organization but nevertheless constitutes a marketplace for securities under existing Exchange Act Rule 3b-16, or the Proposing Release, would be an “exchange” that is required to register with the SEC and comply with Exchange Act obligations.
Providing Custodial Services Is Not Relevant to the “Exchange” Analysis
Commenters raised the issue of custodial services in connection with the “exchange” definition. For example, some commenters argued that DeFi systems should not fall within the “exchange” definition because trading conducted using DeFi platforms does not involve customers depositing assets with a central authority. In response, the SEC clarified that whether a trading platform takes custody of customer assets is generally irrelevant to the analysis of whether a platform may be an “exchange,” as Rule 3b-16 does not require an organization to provide custodial services.[17] In fact, national securities exchanges do not provide custody services.
Considerations Regarding the Notice and Comment Process
Like the comments in response to the Proposing Release, we expect that the Reopening Release will likely generate additional comments from crypto market participants. When considering whether to respond to the Reopening Release (and which questions to respond to), it is important that prospective commenters understand the agency rulemaking notice and comment process and the cornerstones of administrative law and the Administrative Procedures Act (APA).
All comment letters that are submitted in response to a proposed SEC rulemaking will be reviewed and considered by the SEC staff. If the main purpose of a prospective commenter’s submission is to seek clarity from the SEC with respect to the proposed rulemaking, it is imperative that the comment letter is precise. Even so, prospective commenters should consider whether participating in the comment process is the best avenue to seek guidance from the SEC staff. As a general matter, the SEC staff are generally bound by any positions taken by the Commission in the rulemaking process. Accordingly, if the ultimate adopting release regarding Rule 3b-16 leaves no ambiguity regarding the SEC’s intent to apply existing or newly adopted Exchange Act rules to crypto market participants, the SEC staff who administer Rule 3b-16 will look to the language provided in the adopting release. Additionally, the SEC staff, lawyers, and courts will rely on the rulemaking record (which includes comment letters submitted to the SEC and, specifically, the SEC’s response to those comments) to understand the intent of the rule as well as how it is meant to be interpreted and applied.
For market participants seeking to use DLT or blockchain technology in a novel or unique way to facilitate securities transactions, or in the offering and issuance process, working with competent securities counsel is key. Further, collaboration and buy-in from the SEC and/or other applicable regulators constitute the minimum level of compliance.
Conclusion
The ongoing debate between members of the crypto and digital asset industry and the SEC regarding the SEC’s regulatory approach presents a larger question regarding the intersection of innovation, technology, and regulation. To date, various members of the crypto and digital asset industry have released statements concluding that the uniqueness and novelty of the underlying technology used (i.e., DLT and blockchain technology) make the industry generally incompatible with existing securities laws. Chair Gensler acknowledges, and disagrees with, the reliance on this argument as the primary justification for the crypto and digital asset industry’s overall noncompliance with current securities laws. Technology, in a myriad of forms, is a tool used by all industries. The way that it is used determines what rules or regulations might apply. In a circumstance where an existing or emerging technology is used in a manner that violates the existing regulatory framework, the question for both regulators and industry is whether the law, the way the technology is used, or a combination of both must change. Generally, technology has to be used in a manner that complies with existing rules and regulations, regardless of its many use cases that could and or may violate existing rules and regulations.
In light of the Reopening Release, recent statements made by Chair Gensler, and recent SEC crypto assets and cyber enforcement actions, market participants that may (or do) fall within the parameters of the Exchange Act registration requirements should begin to consider and pursue an operationally viable path forward. We expect heightened and continued scrutiny from the SEC staff regarding certain crypto market participants’ compliance with exchange registration requirements. Market participants should review the Proposing Release and the Reopening Release to consider whether, and to what extent, the proposed amendments will affect their business, if adopted as proposed. Platforms that may be affected should begin to familiarize themselves with the registration process and what it entails. Further, market participants should be assessing what ongoing compliance may entail and how to implement a compliant infrastructure. To the extent that market participants are already engaged in activity that requires exchange registration, seeking advice from competent securities counsel is necessary.
Endnotes
[1] See Supplemental Information and Reopening of Comment Period for Amendments Regarding the Definition of “Exchange,” Exchange Act Release No. 34-97309, 88 Fed. Reg. 29448 (May 5, 2023) [Reopening Release].
[2] 15 U.S.C. § 78c(a)(1). Under section 3(a)(1), the term exchange “means 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 performing with respect to securities the functions commonly performed by a stock exchange.”
[3] See Securities and Exchange Commission, "Comments on Amendments to Exchange Act Rule 3b-16 Regarding the Definition of “Exchange”; Regulation ATS for ATSs That Trade U.S. Government Securities, NMS Stocks, and Other Securities; Regulation SCI for ATSs That Trade U.S. Treasury Securities and Agency Securities" (last visited May 8, 2023).
[4] See Amendments Regarding the Definition of “Exchange” and Alternative Trading Systems (ATSs) That Trade U.S. Treasury and Agency Securities, National Market System (NMS) Stocks, and Other Securities, Exchange Act Release No. 34–94062, 87 Fed. Reg. 15496 (Mar. 18, 2022) [Proposing Release].
[5] 15 U.S.C. § 78e. Registered national securities exchanges are also self-regulatory organizations (SROs) and must comply with regulatory requirements that are applicable to both national securities exchanges and SROs.
[6] See e.g., G. Massad & Howell Jackson, The Brookings Institution, "How To Improve Regulation of Crypto Today—Without Congressional Action—And Make the Industry Pay for It" (Oct. 13, 2022); Simi Siwisa & Steffen Kern, World Economic Forum, "Why We Need New Rules and Tools for Cryptocurrencies" (Jul. 28, 2021); U.S. Chamber of Commerce, Center for Capital Markets Competitiveness, "Digital Assets: A Framework for Regulation to Maintain the United States’ Status as an Innovation Leader" (Jan. 2021).
[7] See e.g., Dietrich Knauth, Reuters, "SEC Objections to Voyager-Binance Deal Criticized by U.S. Judge" (Mar. 2, 2023); Hannah Miller & Kailey Leinz, Bloomberg, "Ripple’s CEO Expects a Decision on SEC Suit Over XRP This Year" (Mar. 2, 2023).
[8] See Securities and Exchange Commission, "Chair Gary Gensler: Statement on Alternative Trading Systems and the Definition of an Exchange" (Apr. 14, 2023) [Statement]; see also Reopening Release at 29457 (“The federal securities laws apply equally to systems that trade securities, use DLT, and meet the criteria of Rule 3b-16 as to any other exchange. The federal securities laws are flexible and the use of DLT, or any other technology, does not make compliance incompatible with the federal securities laws.”)
[9] Compliance with Regulation ATS requires, “among other things, meeting the definition of an alternative trading system (ATS) and registering as a broker-dealer.” See Reopening Release at 29448 (internal quotations omitted); see also Regulation of Exchanges and Alternative Trading Systems, Exchange Act Release No. 34-40760, 63 Fed. Reg. 70844 (Dec. 22, 1998) [Regulation ATS Adopting Release].
[10] Reopening Release at 29455 n.71.
[11] See Regulation ATS Adopting Release at 70849.
[12] In its explanation for the proposed amendments, the Commission notes that it removed the word “multiple” from Exchange Act Rule 3b-16(a)(1) to mitigate confusion as to its application to nonfirm trading interest, including request-for-quote (RFQ) systems, and further align Rule 3b-16 with the statutory definition of “exchange,” which does not contain the word “multiple” but includes the plural terms “purchasers and sellers.” See Proposing Release at 15506.
[13] Reopening Release at 29452.
[14] Reopening Release at 29455-56 (“Generally, an entity that engages a service provider or vendor to operate a market place or facilities for bringing together buyers and sellers of securities directs, manages, and oversees the activities of the service provider or vendor. In this instance, the entity, not the service provider or vendor, controls the market place or facilities, and the entity is responsible for compliance with federal securities laws.”)
[15] Reopening Release at 29454.
[16] Id. The Reopening Release also noted that “control” includes the ability to determine or modify, with respect to the market place or facilities, (1) the assets made available for trading, (2) access requirements and conditions for participation, (3) revenue sharing arrangements, or (4) legal or financial agreements or arrangements on behalf of the market place or facility. See e.g., Reopening Release at 29455.
[17] Reopening Release at 29453-54. While providing custodial services generally is not a relevant factor to the exchange analysis, broker-dealers that do provide custodial services—digital or otherwise—may be required to comply with other federal securities laws. See e.g., the Customer Protection Rule, 17 C.F.R. § 240.15c3-3.
