Crypto Exchanges & the SEC’s Proposed Redefinition of an “Exchange”
Recently, the SEC published a proposed new regulation (the “Proposed Rule”) to amend the definition of an “exchange” for purposes of the Securities Exchange Act. Any person whose conduct meets the Proposed Rule’s new definition would be required to register as an exchange or apply for an exemption by registering as an Alternative Trading System (ATS).
According to the Proposed Rule, the redefinition is intended to bring under SEC regulation certain traders in the Government Securities market. However, many observers have noted that the impact of the redefinition is over-broad in terms of its stated intent as it would extend the requirement to register as an Exchange or ATS to many business models previously outside its scope. The new definition is broad enough to cover both centralized and decentralized crypto exchanges . Simply put, the Proposed Rule extends the exchange registration requirement to any person or group that makes available a “Communications Protocol System” to conduct trades.
Given the tension between the SEC and the crypto industry, it is no surprise that crypto exchanges and other players view this move with extraordinary skepticism. Some commentators have described the relationship as a game of cat and mouse. In light of many public statements regarding crypto and crypto exchanges by SEC representatives and the wide array of legal challenges facing the industry, concern regarding this Proposed Rule is merited and invites the question, “what laws and regulations currently apply to crypto exchanges?”
Crypto-Exchanges & Securities Law
There is no special body of law or regulations that govern crypto exchanges. However, provisions of existing regulatory regimes may apply to their activity. Determining which rules apply requires a look into the specific activity carried out by a crypto exchange. This effort should involve, at a minimum, a deep dive into at least the following inquiries regarding the transactions completed and the tokens, coins, or other assets sold on the crypto exchange:
• Are they securities?
• Are they subject to commodities regulation?
• How are the transactions structured?
Narrowing our focus to securities regulation, crypto exchanges must grapple with compliance involving two broad registration requirements.
Any person “engaged in the business of effecting transactions in securities for the account of others” or in the “business of buying and selling securities for his own account” is required to register as a broker or dealer, respectively, and to join an SRO (i.e., FINRA). In determining whether a person is “acting as a broker,” the SEC would look to whether the person regularly participates in securities transactions “at key points in the chain of distribution.” Activities that indicate a person may be acting as a “broker” include: (1) solicitation of investors to purchase securities; (2) involvement in negotiations between the issuer and investors; and (3) receipt of transaction based compensation. Transaction based compensation is the “hallmark” of broker-dealer activity. The SEC interprets brokerage activity broadly. For example, it deems many people who act as investment “finders” for issuers to engage in brokerage activity.
Exchange or ATS Registration
Online sites for trading in securities are generally required to register as broker-dealers and apply for authorization to operate an ATS. Persons that operate an ATS are exempt from the rule that only “exchanges” can provide facilities or a market place for trading in securities. Exchanges are defined by the Securities Exchange Act as “a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood.”
Exchange Act Rule 3b-16, which governs the ATS exemption from exchange registration further defines an “exchange” as any person or group that (1) brings together orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary 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. An “order” is defined as a “firm indication of a willingness to buy or sell a security … including any bid or offer quotation, market order, limit order, or other priced order.” Systems not meeting this two-part test are not “exchanges” under the current definition.
Do the Current Broker-Dealer and Exchange or ATS Registration Requirements Apply to a Crypto Exchange?
Some companies operating crypto exchanges have maintained that they are not covered by the current definition of “exchange” and that they are not otherwise required to register as a broker-dealer. Several public comment letters to the Proposed Rule illustrate this. Their stated reasons include the following:
o The tokens or other digital assets sold by the exchange are not “securities.”
o The crypto exchange does not facilitate or effectuate transactions for the account of others, but rather facilitates peer to peer trades between private parties or with liquidity pools.
o They do not assist parties in negotiating transactions; transactions are disintermediated.
o No actor “uses” non-discretionary methods to settle transactions.
o They do not perform functions commonly performed by an exchange.
o They do not publish price quotes.
o They do not bring together “firm orders.”
The SEC and the Courts have not conclusively weighed in on many of the above arguments specifically in connection with crypto exchanges. The Proposed Rule recognizes that at least some “Communications Protocol Systems” do not fall within the definition of exchange. However, several publications and statements of SEC personnel appear hostile to these arguments in connection with crypto exchanges.
For instance, a 2017 investigate report addressing secondary market trading of unregistered “DAO” tokens noted that the DAO token was a security and that the platforms on which it traded should register as an exchange or a broker-dealer and ATS because they appeared to fit the definition of an exchange. In 2018, the SEC issued a statement on digital assets and trading, confirming its view that Exchange Act Rule 3b-16 contains a functional test and clarifying, “[n]otwithstanding how an entity may characterize itself or the particular activities or technology used to bring together buyers and sellers, a functional approach (taking into account the relevant facts and circumstances) will be applied when assessing whether a system constitutes an exchange.”
Significantly, by referring to the definition of “exchange” in the ATS rules as a “functional test,” the SEC signaled that it will not take a formalistic view of trading systems designed to avoid being literally captured within the definition. Although the SEC has “granted no-action letter to operators of passive communications systems that assist in transactions but do not play a role in effecting transactions in securities,” it is noteworthy that these letters appear to have addressed systems used between, or to communicate with, registered broker-dealers.
Additionally, SEC Chair, Gary Gensler, observed in last year that Coinbase lacked a license to operate as an exchange “even though they have dozens of tokens that might be securities.” He also opined that “with 50 of 100 tokens” there is only a remote probability that any given platform has zero tokens that are securities. Some assets are obviously securities, such as those that are attached to equity ownership or profits interests. Others may provide access to only a good or service (i.e., a utility token) or represent only a tradeable good. Determinatively, Bitcoin and Ethereum have been deemed to not constitute securities.
Whether a cryptocurrency, token, or other digital assets is a security is determined by applying the analytic framework known as the Howey test. Many tokens traded on exchanges—even those labeled or thought of as “utility” tokens—qualify as “investment contract” securities. The SEC has offered a framework for analyzing whether digital assets are “investment contracts” based on the Howey test. Typically, if a token is intended to furnish access to a network that is not decentralized or fully functional and a purchaser of the token would expect the asset’s value to increase based on future efforts of a developer or operator, the token will be deemed a security.
Consequently, even before considering the impact of the Proposed Rule, crypto exchanges should seriously consider taking action to register as a broker-dealer and as an ATS. To recap, this is because many crypto exchanges likely sell coins or tokens that are securities and because of the broad and functional views taken by the SEC in connection with the definitions of “exchange” and “broker.” Virtually any action as an intermediary in a securities transaction can lead to liability exposure for having violated the broker-dealer registration requirement.
Although industry proponents may have plausible legal arguments that they are not a broker-dealer and that their trading system don’t meet the definition of an exchange, defending an enforcement action could be financially devastating for a crypto exchange. Further, participant or statutory underwriter liability could attach to the sale of unregistered securities by or on an exchange (this could depend on the proximity of the exchange and secondary trading to an issuer or an issuance) and could result in liability for violations of Section 5 of the Securities Act.
The Proposed Rule’s Redefinition of Exchange & Impact
The Proposed Rule would redefine exchange (and extend the registration requirement) to include any organization or group of persons that, by way of any “Communication Protocol Systems,” “brings together buyers and seller using trading interest … under which buyers and sellers can interact and agree to terms of the trade.” In addition, “trading interest,” in addition to “an order” is redefined to mean “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.”
Several comments on the Proposed Rule from market participants have observed that it would have a devastating impact—both for the industry and holders of digital assets. They further comment that the Proposed Rule suffers from procedural defects as applied to the digital assets industry and does not comply with the Administrative Procedures Act. Others have opined that the SEC is without statutory authority to redefine exchange as broadly as proposed in the new rule.
Among the challenges noted by industry participants is the difficulty of registering ATS platforms that trade in digital assets with the SEC and FINRA. Further, because of their decentralized nature, at least some decentralized crypto exchanges implemented by “Communications Protocol Systems” may not have any realistic possibility of registering as an ATS. As a result of these and other issues, crypto industry participants have voiced grave concerns and have signaled their willingness to defend future enforcement actions.
Whether the SEC will proceed with the Proposed Rule as written or make modifications to accommodate the digitals assets industry remains to be seen. The public comment period on the Proposed Rule closed April 18, 2022, but the SEC recently reopened it until June 13, 2022. One thing is certain: the story on crypto exchanges and registrations has not been finally written.