Intro & Call to Action
The SEC's new securities exchange / ATS amendment proposal has been published, alongside a strenuous dissent from Commissioner Hester Peirce. The proposal is massive and, as noted by Peirce, encompasses a radical paradigm shift that was not contemplated in the SEC’s previous related concept release and would overrule previous no-action guidance. It does not make express reference to blockchain, DeFi, automatic market-making protocols, etc., but I nevertheless believe the SEC staff is very likely to use its expanded definitions of securities “exchange” to bolster the SEC’s currently weak arguments that AMMs constitute securities exchanges. At the same time, the proposal offers no method of registration and reporting that could actually be followed by anyone who arguably “makes available” an AMM protocol or other DeFi systems—thus, to whatever extent the proposed changes might purport to turn AMMs and other DeFi systems into “securities exchanges”, it is at a minimum irresponsible and thoughtless as regulation. Because the proposal achieves this expansion by providing new restraints on “communication protocols,” I believe it may also be unconstitutional as a restraint on free speech.
Just as one easy way to illustrate the seriousness of this issue, under this new rule, EVEN A BLOCK EXPLORER LIKE ETHERSCAN could be argued to be a SECURITIES EXCHANGE because it could be argued to constitute a COMMUNICATIONS PROTOCOL through which buyers and sellers can interact with smart contracts to communicate TRADING INTEREST resulting in a trade. If the SEC in fact intends such a result, it is clearly unacceptable, and should be deemed an unconstitutional restraint on free speech.
With all that being said, here are my preliminary notes and thoughts, which I hope will also inspire the rest of the industry to scramble to provide comments making clear to the SEC that DeFi should not be covered by this new proposal. We only have 30 days to make our voices heard.
Purpose and Effect of the Amendments
(1) The express purpose of the proposal is to vastly increase the scope of what constitutes a "securities exchange" and who has obligations to register as a "securities exchange" or "alternative trading system for securities" (ATS). The proposal even notes that, in doing so, it would overrule previous SEC no-action letters and guidance giving comfort that certain kinds of systems are not securities exchanges. The gloss provided by SEC Chair Gensler is even broader (I would say, shockingly broad), stating that the changes are meant "to cover platforms for all kinds of asset classes that bring together buyers and sellers."
Revised “Exchange Definition” And Paradigm Shift From “Order-Based” Regime to “Trading-Interest-Based” Regime
(2) The proposal achieves the expansion by radically shifting the SEC's regulatory paradigm for exchanges from a regime oriented around regulating systems that MATCH securities ORDERs to a regime oriented around regulating systems that MAKE AVAILABLE PROTOCOLS that buyers and sellers can use to COMMUNICATE their securities TRADING INTEREST.
No Express Mention of or Accommodation for Blockchain, DeFi, AMMs, Etc.
(3) The proposal does not mention blockchain, AMMs or DeFi, and the registration/reporting requirements would be impossible for persons who arguably "make available" AMMs* (*see below) to comply with. For example, one of the requirements for a registered ATS is to identify, track the orders of and report to the SEC information the ATS's users, which are described as "subscribers"---but those who arguably "make available" AMMs (whether those are deemed to be miners, software providers or front-end operators) do not have such information. Furthermore, those who arguably “make available” AMMs, since they do not control the AMMs, have no means of ensuring that securities or tokens that are integral to a securities scheme are not traded through the AMMs—only the users of the AMMs can decide that for themselves.
Potential Application to Blockchain, DeFi, AMMs, Etc.
(4) Nevertheless, the proposal could be seen as significantly weakening the argument that persons involved in AMMs do not have registration and reporting requirements under the exchange / ATS rules.
In advising clients that the client developing or deploying an AMM, or that the client offering a website that contains information about how to interact with AMMs through a third-party wallet, does not constitute operating a securities exchange, my legal analysis (and, I believe, the analysis of other lawyers) has focused on the existing securities exchange rules. The absence of ORDER-placing and ORDER-matching logic within AMMs under the traditional notion of “orders” (as contrasted with mere expressions of trading interest) was a significant factor in getting comfortable with this legal analysis.
Under this new paradigm, however, the persons arguably "making available" AMMs (for more on who those might be, see below) could be more persuasively argued by the SEC to have exchange/ATS registration/reporting obligations because:
(a) participation as a liquidity provider in a particular AMM pool can potentially be argued to be a COMMUNIATION of TRADING INTEREST regarding the tokens (possibly securities) in that pool; and
(b) the AMM smart contract, or a website providing information about the protocol implemented within such AMM smart contract, can potentially be argued to be a COMMUNICATION PROTOCOL which brings together buyers and sellers through such communications of trading interest.
Unresolved Issues/Questions if Applied to Blockchain, DeFi, AMMs, Etc.
That being said, there are numerous questions regarding how this proposal, if adopted, would or could apply to AMMs
(a) What does "making available" mean?
(i) writing and publishing AMM code?
(ii) deploying AMM code?
(iii) making available a website that helps people use the AMM code through third party wallets, because the website provides information about protocol commands that can be sent to the smart contract through the third-party wallet to achieve indicated user aims?
(iv) the combination of (i) and/or (ii) with (iii)?
(v) being a miner or validator on a blockchain network that enables interacting with the AMM?
(b) Given that the new rule would essentially regulate speech forums, is the new rule constitutional vis a vis the first amendment?
(c) Given that, if AMMs are covered, compliance would be impossible because such systems do not provide any of the persons who might be "making available" the AMM with sufficient powers & information to satisfy the rules, is the new rule unconstitutional?
(d) Does the SEC view this new rule as encompassing AMMs, and, if so, which persons does it view as "making available" AMMs? Does it want them to register/report (which currently appears impossible) or does it want to use the new rule to maintain it is illegal for such systems to exist?
(e) How does this affect interagency relationships? If indeed AMMs are covered, then both SEC and CFTC jurisdiction are implicated because some tokens that trade through them are securities and others are non-securities. In similar circumstances—e.g., regulation of swaps—Congress has passed legislation to allocate authority between the SEC and CFTC to ensure there is only one regulator per platform.
Additionally, communication systems are traditionally under the ambit of the Federal Communications Commission (FCC), not SEC—is the SEC encroaching on the FCC’s authority by seeking to regulate “communications protocols”? (h/t to Angela Angelovska-Wilson for observing this potential issue).
Such potential jurisdictional overlaps call out for Congress to weigh in on, and the SEC must not overstep its bounds and create potentially conflicting regulatory regimes without Congressional input.
We should not underestimate the threat this radical and sudden paradigm shift by the SEC poses to the blockchain and decentralized finance movements. We have been afforded a paltry 30 days to make our voices heard—the SEC must revise this proposal to make clear that it is not intended to, in effect, prohibit the creation and deployment of mere code for peer-to-peer token trading or websites—including even mere block explorers—that merely provide information about the interactions that have occurred or can occur through such code together with information about how to interact with such code. There is no way mere coders or mere website operators can register with FINRA, track the identities and trades of AMM systems occurring on decentralized autonomous blockchain systems or otherwise comply with the ATS/ exchange reporting and registration regime, and therefore, if applied to such persons, this new rule would be banning a vast swathe of technologies and free speech regarding those technologies, which is beyond the SEC’s authority and would constitute an unconstitutional violation of our civil and human rights.