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The obscure SEC rule that critics worry is a backdoor attempt to regulate DeFi

The obscure SEC rule that critics worry is a backdoor attempt to regulate DeFi
SEC Chairman Gary Gensler has said he would like to see DeFi exchanges registered with his agency.
  • The SEC could approve the sweeping proposal as early as this spring
  • Lawyers say the regulation could draw DeFi into the official definition of exchange
  • That could pull decentralised exchanges like Uniswap under the agency’s authority

The US Securities and Exchange Commission (SEC) could approve regulation this spring that, if it goes ahead as drafted, would bring decentralised exchanges into the scope of its regulatory oversight.

The regulator proposed updates to an existing set of rules for electronic trading venues, called Regulation Alternative Trading System (Reg ATS), early last year.

ATS, also known as dark pools, are exchanges on which institutional investors like investment banks buy and sell financial instruments like bonds. Reg ATS was passed in 1999 to provide a safe and orderly environment in which these platforms could operate. Any venue that met the regulatory definition of exchange registers as a “broker-dealer” and is regulated accordingly.

With the proposed updates, lawyers say, the SEC is trying to get decentralised exchanges to register as broker-dealers and thereby come under its authority. Although the 600-page proposal document does not explicitly mention digital assets, blockchain or other related terms, crypto lawyers believe that DeFi protocols are in the SEC’s crosshairs with this proposal.

“The commission has been looking at decentralised exchanges (DEXs) and trying to figure out how to regulate them. That is very difficult: the securities laws generally are focused on regulating intermediaries, and with a decentralised platform, where is the intermediary to regulate?” Stephen Wink, partner at law firm Latham and Watkins, told DL News.

The SEC’s challenge is that users typically do not engage directly with the smart contracts, but rather go through user interfaces like websites. Uniswap, for example, is both Uniswap Labs, the US-registered company that developed the web interface and the smart contracts, but it’s also an open-source suite of protocols maintained by a DAO of contributors who hold its governance token UNI, forming an automated market maker (AMM). Uniswap Labs did not respond to a request for comment on this article.

Uniswap, one of the largest decentralised exchanges (DEXs) by total value locked (TVL)

Lawyers say that language in the proposal captures decentralised exchanges by widening the definition of exchange. Under the regulation as it exists right now, an exchange is a platform that brings together buyers and sellers of securities and matches “firm orders.” The Reg ATS updates would alter that definition to make an exchange anything that “makes available” any electronic method—including what it calls “communications protocols”—to bring together buyers and sellers of any kind of security.

An exchange under this reimagined definition doesn’t have to match firm orders. It just has to create a place or provide a protocol where a buyer and a seller could communicate about making a trade.

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“This notion of ‘making available’ a communications protocol is very expansive, and would capture the user interfaces that individual companies offer to engage on these decentralised exchanges,” Wink tells DL News.

“It solves one of the key problems the commission was seeing when it was thinking about how to regulate these folks.”

‘How an agency undertakes rulemaking should be sacrosanct. They didn’t even engage the digital asset community.’

A letter submitted to the SEC by LeXpunK, a legal advocacy group for the DeFi industry, says this wider definition of an exchange could create liability for organisations and even individual developers who work with smart contracts or provide liquidity to AMMs, among other activities.

“None of these persons would qualify as securities professionals or regulated intermediaries today,” the letter says.

“If US-based developers could incur liability or compliance obligations because of the rule changes, then offshore development will be incentivised at the expense of onshore development.”

Hester Peirce, the Republican commissioner at the SEC affectionally known as “Crypto Mom”, called the Reg ATS amendment an “unmarked backdoor” attempt by the commission to get DEXs under its regulatory umbrella.

Lawyers representing the DeFi industry would agree with this assessment. They say that US government agencies must follow a legal process when making regulation that includes setting out a cost-benefit analysis for whoever is being regulated; taking a backdoor approach mitigates against that.

Total value locked (TVL) in DeFi, across all protocols and chains

“How an agency undertakes rule-making should be sacrosanct. It’s not supposed to be like, ‘Oh well, it’s digital assets so it’s a different standard.’ This is how you figure out whether you can do the rule-making. They didn’t even engage the digital asset community,” says Eric Hess, a lawyer with a long career in setting up ATS and who helped draft the LeXpunK letter.

SEC Chairman Gary Gensler has made it clear that he considers many kinds of digital assets, including tokens, to be securities, and therefore under the jurisdiction of his agency.

He has also expressed concern that trading of digital assets, whether on centralised or decentralised exchanges, is concentrated among a few players, and that he would like to see exchanges registered with the SEC.

“Congress gave us a broad framework with which to regulate exchanges. These crypto platforms play roles similar to those of traditional regulated exchanges. Thus, investors should be protected in the same way,” he said in a speech last year.

The Reg ATS amendments could be finalised within the next couple of months. Lilya Tessler, a partner at law firm Sidley, says that while complex rules can take years to become regulation from proposal stage to implementation, the SEC under Gensler has been pursuing a very ambitious agenda.

“The current SEC is very focused on pushing out a lot of proposed regulations, so they may be more likely now than in the past to adopt this regulation,” Tessler says.

The SEC declined to comment for this article.