SEC Issues Final Rules on “Dealer” Definition
Last Tuesday, the Securities and Exchange Commission (SEC) finalized two rules in a 3-2 vote to clarify which market activities would qualify a person or entity to be a “dealer” under the federal securities laws. The final rule requires those who participate in securities markets or engage in “certain dealer roles, in particular those who take on significant liquidity-providing roles in the markets,” to register with the SEC, join a self-regulatory organization, and comply with federal securities regulations. Furthermore, any liquidity provider, regardless if they deal in traditional finance (TradFi) or DeFi, must register as a “dealer” with the SEC if they control over $50 million in capital.
Despite industry push-back to the rule when it was proposed in 2022, the SEC chose not to make an exception related to digital assets. The final rule states that “Whether a particular activity in the crypto asset securities market, including in the so-called DeFi market, gives rise to dealer activity will require an analysis of the totality of the particular facts and circumstances…any person engaged in buying and selling securities for its own account must consider whether it is a dealer, including under the final rules, and so subject to dealer registration requirements.” The SEC purports that the new definition of “dealer” aligns with the “longstanding historical application of the federal securities laws to securities, including crypto assets that are securities.” However, the rule does not state what kinds of digital assets would be considered “crypto asset securities,” or which crypto-related activities would qualify someone to be a “dealer” of digital assets.
Commissioners Mark Uyeda and Hester Pierce voiced their opposition to the rule and identified the consequences it could have on TradFi and DeFi. Commissioner Uyeda stated that the rulemaking “targets proprietary trading funds (PTFs), private funds, and others who make money by buying low and selling high in the Treasury market, while creating additional regulatory confusion for other markets, including crypto asset securities.” Commissioner Pierce, an outspoken supporter of the DeFi industry, had major concerns about liquidity providers and the unlimited scope of who has suddenly become a dealer: “The rule covers providers of liquidity in crypto asset securities. Not only do the tired questions about when a crypto asset is a security remain, but the rule raises new questions about how the rule will apply in the context of automated market makers (“AMMs”). For example, given that an AMM is a software protocol, who will have to register?”
What does this mean?
The “dealer” rule is a troubling overreach of SEC authority into DeFi and provides no practical guidance on how DeFi industry participants should comply. It is vague and purposefully neglects to treat DeFi markets differently from TradFi. If the rule is enforced, DeFi liquidity providers and AMMs could fall under the SEC’s jurisdiction, and have no way to comply with the rule, therefore leaving them to face some sort of enforcement action.
In May 2022, DEF issued a Comment Letter to the SEC regarding the proposed rule, and discussed several reasons why the rule was overly-broad and unjust as applied to DeFi. We argued that the rule, if it passed: (1) would inhibit innovation and curtail market liquidity competition; (2) would exceed the SEC’s statutory authority; and (3) was not adequately tailored to meet the SEC’s objective. DEF maintains that the SEC should have limited the scope of the final “dealer” rule to persons transacting in the U.S. Treasury and listed equity markets. And, if the SEC intends to regulate any aspect of the digital asset market, it should do so based on congressional directive and collaborate with other federal agencies to achieve reasonable, streamlined rules.
FSOC's 2023 Risk Report
Last week, Janet Yellen, Secretary of the Treasury Department and Chair of the Financial Stability Oversight Council (FSOC), testified in front of the House Financial Services Committee (HFSC) and the Senate Banking Committee to discuss FSOC’s 2023 Annual Report.
In her testimony to both chambers, Chair Yellen addressed FSOC’s focus on crypto assets, as one of five areas the 2023’s Report highlighted, and its associated risks. FSOC’s report also raised concerns about platforms that fail to comply with existing AML regulations, emphasizing the need for legislative action by Congress to “regulate stablecoins and spot market for crypto-assets that are not securities.”
In the House hearing, Chair of the HFSC Patrick McHenry (R-NC) criticized FSOC’s failure to identify and respond to emerging risks, such as the March’s 2023 banking sector turbulence, despite its constant attempts to increase oversight and control over non-bank financial entities by relaxing the criteria for designating Systemically Important Financial Institutions (SIFIs) and putting them under Federal Reserve regulation. Chair McHenry stated, “I would encourage you [Chair Yellen] and your failed federal regulators to get back to the work you've been tasked with. We've already experienced what happens when you take your eye off the ball and get engaged elsewhere. The American people should not have to suffer through that again.”
Relatedly, last Tuesday, Chair McHenry (R-NC), Glenn Thompson (R-PA), Chair of the House Committee on Agriculture, French Hill (R-AR), Chair of the Subcommittee on Digital Assets, Financial Technology and Inclusion, and Dusty Johnson (R-SD), Chair of the Subcommittee on Commodity Markets, Digital Assets, and Rural Development, sent a letter to Chair Yellen demanding her answers on the FSOC’s calls for a spot market regulation. The letter highlighted the efforts made by the the House Committees on Agriculture and Financial Services to provide regulatory clarity and provide oversight over the digital asset markets, mainly through the “The Financial Innovation and Technology Act for the 21st Century (FIT21)”.
Additionally, the letter includes several questions about the FSOC’s role in facilitating coordination and communication between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), as it cites regulatory arbitrage and the different regulatory treatments of digital assets by these agencies. It also seeks clarification on the activities and focus of the Digital Assets Working Group from 2017 to 2023, the application of securities laws to crypto-asset issuers and secondary transactions, the adequacy of reactive legal authority for customer protection, FSOC's view on whether Bitcoin and Ether are considered securities, and the appropriateness of expanding CFTC's jurisdiction to include the spot market in non-security digital assets. The Representatives requested answers by February 20, 2024.
What does this mean?
Federal financial agencies are designated to work together on policy matters, aiming to identify and reduce systemic risks, and FSOC is tasked with facilitating this interagency effort across the regulatory spectrum. However, FSOC has fallen short of its mandate with regards to crypto, and the industry has suffered as a result of it. The industry is in dire need of regulatory clarity from Congress to put an end to regulatory overreach and allow innovators to pave the way to a new financial ecosystem.
HFSC Urged the CFPB to Reopen the Comment Period on Its Proposed Rule on Digital Consumer Payment Applications
On January 30th, House Financial Services Committee (HFSC) Chair Patrick McHenry (R-NC), Rep. Mike Flood (R-NE), and Rep. French Hill (R-AR) sent a letter urging the Consumer Financial Protection Bureau (CFPB) to reopen the comment period on the proposed rule “Defining Larger Participants of a Market for General-Use Digital Consumer Payment Applications.” HFSC asks that the comment period be reopened for an additional 60 days to ensure that the CFPB receives more substantive input from industry stakeholders.
HFSC expressed concerns over the proposed rule and emphasized the potential impacts on the industry from the following three aspects.
First, HFSC’s letter suggests that the proposed rule by the CFPB fails to “justify the need to substantially expand the Bureau’s regulatory scope into the payment industry.” Instead, the CFPB relies on its supervisory authority under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Second, the proposed rule extends the CFPB's oversight beyond necessary boundaries without showing evidence of non-compliance or explaining how new regulations address these issues, demonstrating a potentially unchecked use of power. Third, the proposed rule grants the CFPB authority to oversee activities beyond an entity's general-use digital payment application (as defined by the proposed rule) without justifying the need for such supervision.
What does this mean?
HFSC’s request to reopen the comment period to the CFPB’s proposed rule highlights serious concerns about the rule, not just from legal and policy perspectives but also regarding its impact on the payment industry. As the CFPB expands its reach into areas with new financial protocols, the agency should proceed with caution when introducing new regulations. Rushed or poorly thought-out rules could increase uncertainty and negatively affect industry players. Extending the comment period allows the CFPB to gather more feedback from industry experts and stakeholders, ensuring a better-informed and more effective regulatory framework.
See DEF’s response to the proposed rule.
SEC Drops Lawsuit Against DEBT Box
In a striking turn of events that unfolded over the past months, the Securities and Exchange Commission (SEC) found itself embroiled in controversy after initiating a lawsuit against the cryptocurrency company DEBT Box. The situation took an unusual turn after it came to light that the SEC inaccurately represented to the court that DEBT Box attempted financial flight, accusing DEBT Box employees of moving assets and bank accounts out of the U.S.
These inaccuracies were not trivial; they played a pivotal role in the SEC's previous success in securing a Temporary Restraining Order (TRO) against DEBT Box. The issuance of a TRO is a significant legal action that can have immediate and profound impacts on a company's operations. The fact the TRO was granted signals the seriousness of the allegations and the regulatory body's intent to address them swiftly.
The falsity of the SEC's statements did not remain unchallenged for long. When brought to light, the SEC's failure to address or correct these false statements raised significant concerns about the integrity of its enforcement actions. This lapse in accountability led to a notable development in November when Judge Robert Shelby called for a show cause hearing, asking the SEC to explain itself.
In an admission that underscored the gravity of the situation, the SEC acknowledged fault during the show cause hearing and in filings related to the hearing. This acknowledgment, however, did not immediately rectify the broader implications of the incident. In January, DEBT Box took a stand in their Motion to Dismiss highlighting continued impropriety by the SEC.
The culmination of these events came on January 30th, when the SEC voluntarily dropped the lawsuit against DEBT Box, dismissing the suit without prejudice. This means that while the SEC does not want to continue the immediate legal battle, they leave open the possibility of future action. In moving to drop the suit, the SEC also argued that it should not receive sanctions, a stance that further complicated the discourse around regulatory accountability and fairness. The court has yet to decide whether to dismiss the suit with prejudice and/or grant sanctions against the SEC for its misconduct.
What does this mean?
The significance of these developments extends far beyond the immediate legal entanglements of DEBT Box and the SEC. At its core, this situation raises critical questions about the conduct of the SEC’s anti-crypto crusade. The SEC's actions in this case have been sloppy and overly aggressive, and it demonstrates the agency’s willingness to present false evidence to achieve legal victories against crypto-related businesses. Such tactics not only undermine the trust in regulatory processes but also highlight a concerning "rules for thee but not for me" attitude.