July 5, 2023 – The U.S. Securities and Exchange Commission (“SEC”) has recently ramped up its enforcement efforts on crypto platforms, taking a trio of actions against so-called unregistered national stock exchanges. With its aggressive focus on crypto trading platforms, dissenters of the SEC approach say the SEC poses an existential threat to the industry in the US.
Still, there are rules in the making; the enforcement actions — against Bittrex, Binance and Coinbase — come on the tail end of the SEC’s 3-2 party-line vote to reopen the comment period for the SEC’s proposed amendments to Rule 3b-16 under the Securities Exchange Act to expand the definition. extending an “exchange” (the “Proposed Rules”).
In announcing the reopening, the SEC warned that some trading venues, including decentralized finance (“DeFi”), constitute an “exchange” under current definitions and may be subject to enforcement action:
“[C]currently, certain crypto asset trading systems, including so-called “DeFi” systems, operate as an exchange as defined in federal securities law.
The SEC’s three enforcement actions following the reopening release leave no doubt that it has made law enforcement crypto platforms an enforcement priority. The reopening release also portends extensive platform scrutiny. Now that the reopened commentary period has closed, the SEC could adopt the expanded definition any day, bringing more crypto platforms into its regulatory scope.
I. “Exchanges” and the Consequences of Operating as an Unregistered Exchange
Under the current version of Rule 3b-16, an organization, association or group of persons is considered an exchange or an exchange if this: “(1) [b]brings together the orders for securities from multiple buyers and sellers; and (2) [u]It involves established, non-discretionary methods (whether by providing a trading facility or establishing rules) by which such orders interact, and the buyers and sellers entering such orders agree to the terms of a transaction. “
For an organization, association, or group of individuals to qualify as an exchange, it must register with the SEC as an exchange or register as a broker-dealer and comply with the Regulation ATS.
To comply with the ATS Regulation, an organization must meet the definition of an alternative trading system (ATS) — an organization, association, group of persons or system that (1) establishes, maintains or provides a marketplace or facilities for bringing together buyers and securities sellers; and (2) does not: (i) regulate the conduct of subscribers other than the trading conduct of such subscribers; or (ii) discipline subscribers other than by barring them from trading.
Failure to register as an exchange or broker-dealer may result in you operating as an unregistered exchange, which is a violation of Section 5 of the Exchange Act. For an unregistered exchange, the SEC is authorized to bring civil proceedings to obtain damages, including disgorgement, civil penalty, and precautionary interest.
II. The expanded scope of the proposed “exchange” rules
The proposed rules would make several changes to expand the definition of “exchange”:
The proposed rules define “trading interest” as “any non-fixed indication of a willingness to buy or sell a security that identifies at least the security and its quantity, direction (buy or sell), or price.” In addition, the proposed rules would change the definition of “exchange” to capture not only actual orders on stock exchanges, but also conditional offers and exploratory requests.
The inclusion of “communication protocols” in the proposed rules as an example of an established, non-discretionary method for buyers and sellers to communicate would also broaden the scope of “exchange”. Communications protocols “generally use non-firm trade interests rather than orders to incentivize and guide buyers.”
The reopening release provides the following example of a communication protocol: “If an entity makes available a chat function, which requires certain information to be included in a chat message (e.g., price, quantity) and set parameters and structure… the system should use established communication protocols.”
III. Crypto Trading Platforms as “Exchanges”
The statements made by Chairman Gary Gensler and Commissioner Caroline Crenshaw at the reopening of the commentary period make clear the SEC’s position that the current definition of “exchange” applies to numerous crypto trading platforms. Gensler reinforced this view during recent testimony on April 18, 2023, before the US House of Representatives Financial Services Committee, when he stated that “the vast majority of crypto tokens are securities” and that therefore “many crypto brokers trade in securities and must register.”
The reopening release claims that certain platforms “operate like an exchange” as currently defined, as they “bring together orders from multiple buyers and sellers using established, non-discretionary methods.”
The proposed release estimated the number of trading venues that would be affected by the proposed rules. However, the reopening release states that the SEC has determined on closer inspection that “[m]any of the entities operating such trading systems… may be subject to existing federal securities laws and registration requirements, including the requirement to register as an exchange.
As a result, the SEC believes it originally “overestimated.”[ed]the number of respondents potentially subject to the proposed rules. The reopening release ultimately estimates that the proposed rules would lead to “15-20 new rule 3b-16(a) systems trading crypto asset securities.”
IV. The impact of the SEC’s attacks on crypto trading platforms
As Commissioner Hester Peirce noted in her April 2023 derogatory statement, the SEC has ostensibly taken the position that it will take enforcement action against unregistered crypto trading platforms rather than helping them figure out how to register as exchanges:
“Today’s Commission treats the process of preparing notices and comments not as a conversation, but as a threat.”
Even assuming the feasibility of registration, there is a monetary cost of compliance. The reopening release admits that the SEC “has a greater degree of uncertainty in its analysis of the costs the proposed rules would impose on market participants for crypto-assets than in its discussion of costs for non-crypto-asset securities.” Consequently, “actual costs may exceed these estimates.”
There are also implications for the wider market beyond the financial costs borne by individual platforms. Commissioner Peirce predicts that the proposed rule will “embrace stagnation, enforce centralization, spur expatriation and welcome the extinction of new technology”.
Several commentators on the proposed rules share Commissioner Peirce’s fears:
• “Digital Assets and DeFi present a tremendous opportunity for the United States… This proposed rule would hinder development in the Digital Asset space and reduce the competitiveness of the United States.”
• “These regulations are rushed, too broad and stifle the emerging technology that benefits millions of people.”
V. Key Takeaways
It is critical to consult a legal advisor to determine whether your company, as a crypto trading platform, is currently or would be forming an exchange under the proposed rules. To determine this, legal counsel can help determine whether securities are trading on your platform.
Importantly, crypto assets are not securities per se. Rather, the analysis is governed by the four-pronged Howey test: (1) investment of money (2) in a joint venture (3) with an expectation of profit (4) solely on the efforts of others. SEC v. WJ Howey Co., (U.S. Supreme Court 1946). This means that whether or not a particular transaction involving crypto-assets constitutes the offer and sale of a security depends on the facts and circumstances. Legal advice can also help platforms think creatively about how to structure their business in light of Rule 3b-16 and Regulation ATS.
Finally, it is imperative not to delay seeking guidance. Among other things, the longer a trading platform operates as an unregistered exchange, the more profits can increase, which could lead to a higher amount of forgiveness due to any enforcement action, and that could in turn lead to a higher bias interest rate also.
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