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SEC's Exceedingly Broad "Exchange" Proposal Warrants Reconsideration

Today, the DEF submitted a comment letter in response to the SEC’s proposed “Amendments to Exchange Act Rule 3b-16 Regarding the Definition of Exchange.” The Proposal’s expanded definition of an “exchange” is so broad that it could be interpreted to cover DeFi market participants, yet the rule doesn't specify which or why—it doesn’t even mention “crypto,” “DeFi,” or “digital assets” once.

Filling out an application.

In essence, the Proposal would expand the application of regulations like those designed for the New York Stock Exchange to any entity that “makes available” a “communication protocol system” that individuals could use to express interest in trading a security. This definition has almost unlimited reach. That the Proposal specifically excludes chat platforms like Facebook Messenger and utilities like cellphones from being newly designated as securities exchanges—and therefore being responsible for somehow complying with regulations designed for stock exchanges—evidences its breadth.

We are concerned that this vagueness could be seriously detrimental to the digital asset ecosystem in the United States. The all-encompassing definition could saddle non-intermediaries in the ecosystem, like software developers, with a host of legal and regulatory obligations that only financial intermediaries like stock exchanges can implement. Foisting unworkable registration requirements onto DeFi developers or other market participants could inhibit their ability to continue to innovate in ways that are currently improving U.S. financial markets.

DeFi protocols provide investors the important benefits of transparency, fair and open access, constant uptime, elimination of broker risks and reduced costs, among others. But the Proposal could be read to ban this beneficial market structure innovation, as well as a wide range of established communications and software tools that have never been, and should not be, regulated as exchanges.

The SEC has not justified, and cannot justify, such a sweeping change. Requiring DeFi protocol developers or other market participants to register as exchanges would advantage existing incumbents and technologies while stunting continued modernization of the U.S. securities markets, to the detriment of all market participants and to the benefit of competing markets abroad.

The Proposal exceeds the Commission’s statutory authority. An organization, association, or group that merely “makes available” a CPS, without further involvement in transactional execution and related services that are characteristic of exchanges, does not satisfy the definition of an “exchange” in Section 3(a)(1) of the Exchange Act. To avoid overly broad regulation of organizations, the Exchange Act stipulates that an exchange must perform functions “commonly performed by a stock exchange.” The statutory definition does not, and has not been construed to, apply to entities or groups that merely offer communications and software services used in connection with trading activities but that have no ongoing relationship with users and no involvement in transactions. The Commission's Proposal would radically expand the definition of “exchange” to regulate tools and applications that were previously understood, including by the Commission itself, to fall outside of the Commission’s exchange registration framework.

In addition, we argue that DeFi protocols, due to their decentralized nature, also do not constitute an organization, association, or group under the Exchange Act. Courts have traditionally been reluctant to expand the “group of persons” statutory requirement under the Exchange Act and the D.C. Circuit recently stated that “the term ‘group of persons’ remains murky, and vigilance is necessary to ensure the term is not stretched too far.” In determining whether a particular service provider constituted a “group of persons” under the Exchange Act, the D.C. Circuit focused in particular on whether the parties were close affiliates of each other and whether such parties were acting in concert. Thus, developers and users of DeFi protocols could not qualify as a “group of persons” because the (a) developers have no ongoing relationship with either market participants or other financial providers and merely make tools available for parties to communicate and (b) users are acting independently of each other.

We argue that the Proposal does not provide fair and sufficient notice under the Administrative Procedure Act. The Administrative Procedure Act (“APA”) requires federal agencies to provide notice and an opportunity to comment on regulatory proposals. To satisfy the rulemaking requirements of Section 553 of the APA, an agency “must provide sufficient factual detail and rationale for the rule to permit interested parties to comment meaningfully.” Integral to an agency’s notice requirement under the APA “is its duty to identify and make available technical studies and data that it has employed in reaching the decisions to propose particular rules.” The Proposal self-evidently fails to meet these requirements. First, because the Proposal’s cost-benefit analysis is insufficient under the Exchange Act, the Proposal does not provide affected parties with the necessary information to formulate their views. Second, the Proposal does not give adequate guidance on the parties that would be affected by the rule because the amendments to the definition of exchange are overly broad and could potentially encapsulate almost any tool that allows parties to communicate a trading interest. Finally, the Commission has not given the public time commensurate with the length, complexity, and significance of this rulemaking to properly comment on the proposal.

We also argue that the Proposal raises First Amendment concerns. By expanding the definition of “exchange” to encompass even those software applications that simply facilitate communication, the Proposal would impose a significant burden on the development and publishing of open-source software code. It therefore imposes unconstitutional limits that are prohibited under the First Amendment to the Constitution. Courts have traditionally determined that restrictions on the types of code at issue here must advance a substantial governmental interest that is unrelated to the suppression of free expression and must not burden substantially more speech than is necessary to further that interest. The Proposal’s undefinable breadth would burden expression far beyond the execution of a securities trade, indicating that the Proposal burdens substantially more speech than is necessary.

Read our full comment letter.

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